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Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australasian Finance and Banking Conference, Sydney, 17 December 2013. | Guy Debelle: Remarks on liquidity Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australasian Finance and Banking Conference, Sydney, 17 December 2013. * * * Thank you to Fari for again organising a good conference. Today I will make a few points about liquidity. I have spoken about this on a number of other occasions, but one year out from the Basel III liquidity regime becoming fully operational, it is timely to do so again.1 Why do we have liquidity regulation? The fundamental answer is that banks engage in maturity transformation. They borrow short and lend long. This is a service which society values. There is a demand for banks to provide liquidity services. Depositors place their savings with a bank but want to be able to withdraw some part of their funds at short notice. A corporate treasurer wants to have the company’s funds in an account where they can be accessed quickly to meet the needs of the firm. At the same time, we prefer to have our loans for substantially longer periods of time. It would be particularly inefficient and bothersome if we had to renegotiate our home loan on a monthly basis. More importantly, it would be very difficult to make any sort of long-term planning or investment decision if there were no long-term loans available. This desire for liquidity on the one hand and long-term lending on the other is intermediated by the financial sector and the banking sector in particular. But the maturity transformation this entails exposes the banking sector to liquidity risk. If all the depositors wanted their money back in a hurry, the bank would not be able to meet that obligation without either calling in their loans, which may be contractually impossible, or trying to sell them. The latter is often practically impossible to do at short notice, or even if it is possible, may only be able to be carried out by selling the assets (such as loan portfolios) at fire-sale prices. Neither of those outcomes is socially desirable. Fire sales run the risk of generating contagion to other financial institutions as the price of the asset falls, as they may well hold that same asset too, and/or may use it as collateral in transactions themselves. Fire sales also limit the ability of the institution making the sale to make good on its obligations. So there are externalities to the asset that is being sold, as well as to the financial system as a whole. Liquidity regulation addresses this issue by ensuring that the banking system has some level of liquidity at hand to meet predictable liquidity demands. In the case of Basel III, banks need to have available sufficient liquidity to meet a 30-day stress scenario. In simple terms, a bank must have enough liquid assets that can be easily liquefied (not at fire-sale prices) to meet any of its liabilities that fall due within that 30-day period. In Basel III, these assets are labelled high-quality liquid assets (HQLA). See Debelle G (2013), “The Impact of Payments System and Prudential Reforms on the RBA’s Provision of Liquidity”, Address to the Australian Financial Markets Association and Reserve Bank of Australia Briefing, Sydney, 16 August. Also see Stein J (2013), “Liquidity Regulation and Central Banking”, Speech at the “Finding the Right Balance” 2013 Credit Markets Symposium sponsored by the Federal Reserve Bank of Richmond, Charlotte, North Carolina, 19 April. Available at <http://www.federalreserve.gov/ newsevents/speech/stein20130419a.htm>; Coeuré B (2013), “Liquidity Regulation and Monetary Policy Implementation – From Theory to Practice”, Speech at the Toulouse School of Economics, Toulouse, 3 October. Available at <http://www.ecb.europa.eu/press/key/date/2013/html/sp131003.en.html>. BIS central bankers’ speeches This implies that more liquid liabilities, those with less than 30 days to maturity, will be more costly for the bank to provide. Hence, one would expect to see an increase in the cost to the customer of obtaining that liquidity service. We have seen this start to occur in Australia as the implementation date of Basel III, 1 January 2015, comes into sight. But my sense is that there is more of this repricing still to come. As I have said before, the rate of return available on at-call accounts does not seem to sufficiently reflect the cost to the bank of providing such liquidity. Maybe we will have to wait for 31 December 2014 for this to occur, as there is potentially a large first-mover disadvantage from being the first to reprice the product. The lower interest rate is likely to see customers move rapidly to a competitor who has yet to reprice. In the online account world, the transactions costs of switching are very low, and the evidence is that the response rate to small interest rate differentials is rapid. While there may be more repricing to come, it is worth mentioning that as part of the Basel III liquidity standards, banks are required to demonstrate to APRA that they have an appropriate liquidity transfer pricing model. APRA is conducting a trial run of the new liquidity regime over the coming year and one might expect these new liquidity pricing models to come into effect as part of that. This will affect not just deposit pricing but pricing on the other side of the balance sheet, namely loans, as well. It will have a particular impact on contingent facilities such as lines of credit. To return to the issue of HQLA for a minute. As most of you are aware, there is a shortage of HQLA in Australia. The stock of government debt on issue, both Commonwealth and state, is well short of the liquidity needs of the banking system. Hence, as part of the liquidity regime, the Reserve Bank will be offering banks access to a Committed Liquidity Facility (CLF). For a fee, the Reserve Bank will make available sufficient liquidity (against eligible collateral) to address the shortfall of HQLA beyond the banking system’s holdings of Commonwealth and state government debt. The motivation for doing so reflects the societal gains that I talked about earlier from the banking system engaging in an appropriate amount of maturity transformation. The pricing of the CLF is aimed at replicating the cost of holding HQLA in the form of government debt. That is, it is designed to be the same as the liquidity premium embedded in government paper. The fact that there is a cost to the banking system of holding HQLA, either in the form of government debt or in the fee paid to have access to the CLF, is in keeping with one of the main motivations of the Basel III liquidity regime, namely that banks engage in the appropriate amount of maturity transformation. Generally speaking, liquidity was underpriced prior to 2007 with the result that excessive maturity transformation was undertaken, manifest in some cases in highly unstable short-term funding structures. The new liquidity regulation increases the cost of liquidity, but it is not designed to increase the cost so much that insufficient maturity transformation is undertaken from society’s point of view. Having talked about liquidity from the banking system’s point of view, I will finish with a few thoughts on liquidity in the superannuation (pension) system. In many ways, liquidity issues in the super sector are very similar to those in the banking sector. While the super sector generally thinks of itself as being in the asset management business, it is obviously very much in the intermediation business. It takes in savings and then invests them in a wide array of assets. Because of the portability of super accounts as well as the ability of superannuants to change their asset allocation at relatively short notice, the super sector is also in the business of maturity transformation. Some, potentially unknown, share of its liabilities may be called on at short notice. But some of its assets are long-dated and not easily liquefied at short notice, or if they can be, only at fire-sale prices. As with banks, society values the maturity transformation that the super sector undertakes, particularly in terms of the funds it provides for longer-lived projects. But as with the banking system, there is an optimal degree of maturity transformation and an optimal amount of liquidity to be held. It is desirable that super funds don’t hold all their assets in highly liquid BIS central bankers’ speeches form for the fear that all of its members may withdraw their funds all at once, just as banks don’t put all their assets in liquid form for the fear that a bank run might occur. But at the same time, it is not desirable for all of a super fund’s assets to be invested in highly illiquid assets. To some extent, the super sector’s relatively large allocation to equities, which are, in principle, easily liquefied, but relatively small allocation to fixed income, which is not easily liquefied, may reflect some of these liquidity considerations. But at the heart of it, these liquidity management issues are very similar to those facing a bank. I think many of the principles of liquidity management translate from the banking sector to the super sector, although I have the sense that this is not yet fully appreciated. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 12 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 18 December 2013. | Glenn Stevens: Reflections on the global economy and recent economic and financial developments in Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 18 December 2013. * * * Madam Chair Members of the Committee Thank you for the opportunity to meet with you today. I look forward to constructive engagement with you during the 44th Parliament. As we reach the close of an eventful year, it is perhaps worth reflecting on some key themes, starting with the global economy. At the meeting with the previous Committee early in the year, we noted several developments. Fears of a euro area break-up had abated. The United States economy was gradually recovering, and the slowdown in China had run its course. These outcomes were roughly as expected, though perhaps of greater significance at that time was the fact that various “downside risks” had not materialised. Global growth was running below average, though not disastrously so. It was thought likely to pick up a bit in 2013. The period since then has been largely more of the same. The euro area economy contracted in the first part of the year, but may be starting to grow again. It still faces immense challenges with its banks and public finances, and some years of uncertainty. But once again the worst fears have not been realised. The United States continues a path of gradual recovery, despite the budget “sequester” and the divisive debate about the debt ceiling. The recovery is more gradual than policymakers there would like but that often is the nature of things after a financial crisis. China is growing at a solid pace, about in line with policymakers’ announced intentions, despite concerns it might slow more sharply. Global growth was probably about 3 per cent in 2013, just a little less than in 2012. The pick-up expected has not eventuated as yet, though most forecasters still seem to see reasonable prospects of it occurring next year. So the past year can perhaps be labelled as: not quite good as hoped for, but not as bad as feared. Looking ahead, the issue that most people are focusing on is the so-called “tapering” of US monetary policy. What is meant by this is that the Federal Reserve is expected, at some point, to moderate the rate at which it buys securities in the market, which is presently US$85 billion per month, and eventually to stop purchases. We don’t know when that process will begin. The Fed has said that it will depend on economic conditions, as obviously it must. Moreover it will only be a step on what is likely to be a fairly long path back towards “normal” monetary policy. We can be fairly sure, though, that there is ample potential for this shift in direction to reverberate around global markets. That’s what usually occurs when the Fed changes course. The anticipation of this has already been a factor affecting markets, including in particular those in some important “emerging market economies”, at various points this year. It is sensible to assume that this will be the case over the period ahead, as “tapering” begins and as market participants try to ascertain its extent and pace. Turning to the Australian economy, in February we felt that growth had moderated somewhat and would be below trend for a while, within a range of 2–3 per cent for 2013. Broadly speaking that is what has occurred. Our most recent Statement on Monetary Policy, released BIS central bankers’ speeches in November, put likely GDP growth within that range. The recently released September quarter data don’t cause any material change to that view. This result reflects quite subdued growth in private domestic demand, partly offset by quite strong growth in exports. The very large run-up in mining investment has reached its peak, while non-mining investment remains at a low ebb, and dwelling investment spending is only in the early stages of an upturn. Consumer spending has been rising, but at a below average pace, as people adjust to slower growth in income and look to contain or reduce debt. Inflation has remained consistent with the 2–3 per cent target. For the year to December, it looks as though the Consumer Price Index will have risen by about 2½ per cent, with underlying inflation perhaps a little below that. Our assessment is that inflation will remain consistent with the target over the next one to two years. Looking ahead, resource sector investment will decline – gradually at first but more quickly thereafter. It will most likely fall considerably over the next few years. There is therefore scope for other forms of private demand to grow more quickly, the more so as government spending is scheduled to be subdued. Investment in dwellings shows clear signs of a significant increase, and exports of resources will continue to rise strongly. It is likely that capital spending by firms in some sectors outside the resources sector will eventually pick up, but this will take some time yet and it will be against the backdrop of a challenging environment. Consumer demand is likely to grow at a rate close to that of income. Higher wealth and confidence could see the saving rate decline a little, but consumption will not be the same driver of growth that it was before the financial crisis. Putting all this together, our expectation is that the below-trend growth in GDP we have seen for a while now will probably continue for a bit longer yet. Over the more medium term, there are good grounds to think that growth can strengthen. Eventually more capital spending will be required in some of those sectors where it is very low at present. The corporate sector in aggregate has high reserves of cash, financial intermediaries and capital markets are willing to lend, and interest rates are low. If the nascent improvement in “confidence” we have seen can be sustained, that will help to achieve better growth. In fact, we could aspire to a period during which growth could be a bit above trend for a while, since spare capacity in the economy has increased a bit over the past eighteen months or so. Monetary policy has been playing its part to support demand. Because inflation has been consistent with the target, the Board has been quite comfortable in easing policy by a significant amount. The cash rate has been reduced twice more since we last met with the Committee, and by a total of 225 basis points over the past two years. Borrowing rates are at their lowest levels in a long time. The returns to savers for holding safe assets have commensurately declined, and this has clearly prompted substitution towards other assets, including equities and dwellings. The rate of credit growth has remained quite low thus far, though it is now increasing a little, as housing loan approvals have moved up quite noticeably over recent months. Low interest rates are doing the sorts of things we expect them to do. This is the way expansionary monetary policy works. The exchange rate has also behaved, of late, more as might be expected in such circumstances: that is, it has declined. From about US$1.03 at the February hearing, it has fallen by about 13 per cent. The Bank has described the exchange rate as “uncomfortably high”, and suggested that balanced growth in the economy would probably require a lower exchange rate. The Board has maintained an open mind about whether we may need to lower interest rates further. At this point, however, there are few serious claims that the cost of borrowing per se is holding back growth. On the contrary, monetary policy is supporting higher spending by altering incentives as between spending and saving, and working to create an environment in asset and credit markets that eases the restraints on some sorts of activity. BIS central bankers’ speeches In the end, though, firms and individuals have to have the confidence to take advantage of that situation. They have to be willing to take a risk – on a new project, a new product, a new market, a new worker. Monetary policy can’t force spending to occur. That is why the conduct of other policies is also important. The myriad things which can make it harder or easier for businesses to innovate, to change their ways of doing things, to avoid unnecessary costs and to be more productive, all matter. No single one is decisive in itself; but collectively, they are crucial. It is hard to escape the feeling that we as a society have tended, for quite a long time now, to go about our decisions on such matters while making the assumption, perhaps without realising it, that solid growth of the economy will simply continue, and that it won’t be affected by these other choices of various kinds. We are at a moment now when that assumption has to be questioned. The path of pro-growth, pro-productivity, confidence-building reforms would mean that the basis for investment and growth in real incomes would improve. That would allow consumption to grow without recourse to excessive borrowing. It would provide a revenue base for governments to provide the services and infrastructure the community needs. And so on. The alternative path is a much less attractive one. Before I conclude, a few words on payments and regulatory matters. As I mentioned at the February hearing the Payments System Board has been working to encourage industry to put in place the infrastructure to make real-time payments capability for the community a reality over the next few years. Good progress has been made, though there is a long way to go. An early milestone was reached a few weeks ago when the settlement of direct entry payments, amounting to about $50 billion per day, moved to same-day settlement, as opposed to the previous practice of settling the next day. Quite substantial changes to operational arrangements in the private sector, and in the Reserve Bank itself, were required to achieve this. But it was worth doing because it lowers risk in the system and helps faster access to funds. On financial regulation, the global effort at building a stronger framework continues. The Financial Stability Board has been clear about the priorities over the coming year, under the headings of implementation of Basel III changes, continuing towards completion of a regime for “too big to fail” financial institutions, making derivatives markets safer and making sure “shadow banking” activities have appropriate oversight. Australia, as chair of the G20 this year, welcomes this prioritisation and has indicated that it supports the FSB as it seeks to achieve concrete results by the time of the Leaders’ meeting in Brisbane next November. Australian regulatory authorities continue, meanwhile, carefully to implement internationally agreed reforms, with due regard to local conditions. With those remarks, Chair, we are here to respond to your questions. BIS central bankers’ speeches | reserve bank of australia | 2,013 | 12 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) Economic and Political Overview, Sydney, 14 February 2014. | Christopher Kent: The resources boom and the Australian dollar Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) Economic and Political Overview, Sydney, 14 February 2014. * * * I thank Jonathan Hambur, Daniel Rees and Michelle Wright for assistance in preparing these remarks. I would like to thank CEDA for the invitation to speak here today. I thought I would take the opportunity to talk to you about the implications of the resources boom for the Australian dollar. The past decade saw the Australian dollar appreciate by around 50 per cent in tradeweighted terms (Graph 1).1 The appreciation was an important means by which the economy was able to adjust to the historic increase in commodity prices and the unprecedented investment boom in the resources sector.2 Even though there was a significant increase in incomes and domestic demand over a number of years, average inflation over the past decade has remained within the target. Also, growth has generally not been too far from trend. This is all the more significant in light of the substantial swings in the macroeconomy that were all too common during earlier commodity booms.3 The high nominal exchange rate helped to facilitate the reallocation of labour and capital across industries. While this has made conditions difficult in some industries, the appreciation, in combination with a relatively flexible labour market and low and stable inflation expectations, meant that high demand for labour in the resources sector did not spill over to a broad-based increase in wage inflation.4 So the high level of the exchange rate was helpful for the economy as a whole. But now that the terms of trade are in decline and the resources boom has begun the transition from the investment to the production phase, lower levels of the exchange rate will assist in achieving balanced growth in the economy. While my focus today is on the relationship between the resources boom and the exchange rate, at the outset I should note that this is only one factor – albeit a very important one – influencing the exchange rate. I will touch on some of the other factors later in my discussion. From the mid 1960s to the mid 1970s, the nominal TWI appreciated by about 35 per cent. Prior to that, there was a substantial appreciation after World War I, when the Australian pound was fixed to the British pound, which in turn had returned to the gold standard at its pre-WWI rate. For example, see Stevens G (2011), “The Resources Boom”, RBA Bulletin, March, pp 67–71; and Plumb M, C Kent and J Bishop (2013), “Implications for the Australian Economy of Strong Growth in Asia”, RBA Research Discussion Paper No 2013–03. For a discussion of these episodes, see Atkin T, M Caputo, T Robinson and H Wang (2014), “Macroeconomic Consequences of Terms of Trade Episodes, Past and Present”, RBA Research Discussion Paper No 2014–01; and Battellino R (2010), “Mining Booms and the Australian Economy”, RBA Bulletin, March, pp 63–69. Moreover, by reducing the cost of imported goods and services, the appreciation helped to offset the rise in domestic cost pressures associated with the investment boom. BIS central bankers’ speeches Graph 1 Exchange rate mechanics At the most basic level, the exchange rate depends on the (net) global demand (by foreigners and Australians) for all things denominated in Australian dollars, relative to demand for all things denominated in foreign currencies.5 This includes goods and services available for purchase now and in the future, as well as claims on profits or returns to financial assets denominated in Australian dollars. The demand for Australian goods and services will depend, in part, on the real exchange rate – that is, the level of Australian prices (and wages) relative to those of the rest of the world. And the demand for Australian dollar assets, both physical and financial, will depend on expectations about their returns relative to those of comparable assets elsewhere in the world. The exchange rate depends not only on the current demand for Australian goods, services and assets but also on expectations of all future demand. So, to the extent that it is determined in efficient, forward-looking markets, the nominal exchange rate today should embody relevant information about the future. In theory at least, this means that although the nominal exchange rate can respond to future news, it shouldn’t move in a way that is To be clear, Australian exports paid for in US dollars (as is true of many commodities) will still lead to a demand for Australian dollar-denominated assets to the extent that the revenue finds its way into Australian dollar-denominated bank accounts, via repatriation by Australian owners of their export receipts, for example. BIS central bankers’ speeches predictable today.6 However, periodically the exchange rate appears to deviate from what historical relationships with key determinants would suggest. During such episodes, if we assume that history is a good guide, and that we have measures of the right set of determinants, this in turn implies the potential for a correction in the exchange rate sometime in the future. The questions though are whether history is a good guide, have we given appropriate weight to each of the determinants, and when (if at all) might such a correction occur? The effect of the resources boom The terms of trade – the ratio of the price of our exports to imports – have always been an important determinant of our exchange rate. The emergence of China onto the global economic stage at the turn of the millennium (after it joined the World Trade Organization) led to a large, and largely unanticipated, rise in global commodity prices and saw the near doubling of Australia’s terms of trade between 2003 and 2011 (Graph 2). Graph 2 Other than in a smooth fashion to account for any interest rate differential. See Sarno L and M Taylor (2002), The Economics of Exchange Rates, Cambridge University Press, Cambridge UK. BIS central bankers’ speeches The gradual realisation that the world was willing to pay a lot more for the commodities we had in abundance, and that this was likely to be true for some time, led to a significant increase in the demand for Australian assets tied to the production of commodities. This reflected a significant increase in the expected return to capital in the resources sector. There was also an increase in the demand for Australian labour and materials, to help build and then operate the new extraction, production and transport facilities that have been, and are still being, put in place in the resources sector. These developments implied a significant increase in the demand for Australian dollars and hence led to an appreciation of the exchange rate. We can trace out the sources of the additional demand in terms of the three overlapping phases of the resources boom as follows: (i) During the first phase – the boom in the terms of trade – we see a price effect. Higher commodity prices lead to more export revenue. Part of this revenue accrues as profits to Australian owners of existing resource and resource-related companies, wages for workers at these companies and taxes for Australian state and federal governments. Also, foreigners wanting to buy existing Australian resource assets add to the demand for Australian dollars for a time. (ii) During the investment phase of the boom, funds from offshore owners are used to pay Australian workers and resource-related firms putting additional capital in place in the resources sector. This has accounted for much of the capital flowing into Australia over the past few years (Graph 3).7 Importantly, this source of demand for Australian dollars will decline as resources investment turns down. Absent further increases in commodity prices, the discovery of new mineral deposits, or a reduction in the costs of developing and extracting higher-cost deposits, we cannot expect investment to remain at recent levels.8 (iii) Finally, there is a quantity effect during the production phase of the boom. This follows from the additional export revenue generated by the new resource projects. Some of this will accrue to Australian owners of the new projects and infrastructure, some will go towards paying workers and suppliers supporting the new facilities, and some will go to paying taxes owed in Australia. The rest will remain in the hands of foreign owners. The effect of the higher commodity prices on the nominal exchange rate at any point in time will depend on the expected sum of these different flows into the future. Also, there may be offsetting reductions in inflows to other sectors of the economy, particularly those adversely affected by the appreciation of the exchange rate. Clearly, determining this sum is no easy task and is subject to considerable uncertainties. For a discussion of the impact of the mining boom on cross-border financial flows, see Debelle G (2013), “Funding the Resources Investment Boom”, Address to the Melbourne Institute Public Economic Forum, Canberra, 16 April. Whether the investment is undertaken by Australian or foreign residents need not affect the demand for Australian dollars. For example, Australian residents could choose to borrow offshore to fund the investment in the resources sector (assuming unchanged saving and investment behaviour elsewhere in the economy). This would lead to inflows of capital during the investment phase, followed by outflows associated with the servicing of that debt during the production phase. It is worth noting that a decline in the Australian dollar will help to reduce these costs. Also, gross investment needs to be higher to offset the effects of depreciation on the now higher level of the capital stock. BIS central bankers’ speeches Graph 3 One aspect of the uncertainty is the path of commodity prices themselves. Indeed, the full extent of the rise in commodity prices only became clear over a number of years, starting from around the mid 2000s. This gradual updating of the outlook for commodity prices meant that the exchange rate didn’t jump higher in one step. Instead, it moved higher over time as commodity prices increased. Another aspect of the uncertainty is the extent to which the higher commodity prices influence the three different flows I’ve just described. This will depend in turn on a number of things, including: • how much extra export revenue is earned by existing resource operations and how much of that accrues to Australian residents; • the extent of new investment in the resources sector; • how much of the investment expenditure is accounted for by Australian workers and companies helping to put the physical capital in place; and • how much additional export revenue is generated by the new production facilities and how much of that accrues to Australian residents? BIS central bankers’ speeches Using history as a guide These are very difficult things to know in advance. We could try to estimate the three types of flows directly – perhaps with reference to past behaviour – and then update these estimates as we observe the flows over time and the evolution of the economy more generally. That, in essence, is what foreign exchange markets do one way or another. Alternatively, we could start the process by estimating a model linking the exchange rate to some of its key determinants. This is not meant to imply that past behaviour provides an “optimal” benchmark, but it can be a useful guide nonetheless. One approach is to run a regression of the real exchange rate against the terms of trade and a measure of the (real) interest differential (between Australia and those of large countries with open capital markets). It turns out that this relatively simple “reduced-form” model produces reasonable statistical results over a long period, which doesn’t mean that it is very accurate, just that there are no obvious contenders that are better. Graph 4 compares the actual real trade-weighted index of the Australian dollar (the real TWI) with estimates of the medium-term “equilibrium” exchange rate from the model I just described. This is the level that the exchange rate has tended to settle at over time for given levels of the terms of trade and the interest rate differential.9 We can see that the exchange rate has, on occasions, deviated noticeably and for some time from the “equilibrium” estimates.10 The shaded band around the “equilibrium” gives a sense of the standard deviation of the actual exchange rate from the model estimates. However, even this range suggests more precision than may be warranted, since the level of the “equilibrium” can vary quite a bit depending on the sample period used for estimation. In terms of recent experience, this analysis suggests that prior to the peak in the terms of trade in late 2011, the exchange rate had increased broadly in line with what past behaviour would have suggested. But thereafter, the exchange rate drifted higher still until early 2013, even though the terms of trade fell quite sharply from September 2011 and the interest differential had started to decline from early 2012.11 The deviation of the exchange rate from the estimated equilibrium over the past couple of years was not unprecedented. Nevertheless, on a number of occasions over the past 18 months or so the Bank pointed to the high level of the exchange rate, noting that it had not declined in response to changes in these fundamental determinants.12 This concern can also be explained by considering changes in the exchange rate in the context of how the economy more broadly has evolved over this period. The model also incorporates short-run variables that are intended to capture near-term financial market influences on the behaviour of the real TWI. These include the change in the CRB commodity price index, the change in the real S&P 500 total return index and the change in the VIX index of expected US equity price volatility. For an early discussion of one such episode around the turn of the millennium, see Rankin B (1999), “The Impact of Hedge Funds on Financial Markets: Lessons from the Experience of Australia”, in D Gruen and L Gower (eds), Capital Flows and the International Financial System, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp 151–163. It is hard to argue that the full extent of the rise in the terms of trade up to September 2011 and its subsequent decline were well predicted by markets or forecasters more generally. Leading up to the peak, forecasts tended to under-predict the terms of trade (Plumb et al 2013), and around the peak, forecasters tended to under-predict the subsequent decline. See, for example, Stevens G (2012), “Opening Statement to House of Representatives Standing Committee on Economics”, Canberra, 24 August. BIS central bankers’ speeches Graph 4 It makes sense to include the terms of trade and the interest rate differential in a model of the exchange rate because they capture, at least in part, the extent of any excess demand pressure in an economy (relative to other economies). An increase in demand for an economy’s factors of production and a reduction in its spare productive capacity will tend to imply a higher return to capital and usually be associated with higher yields on financial assets. Hence, all else equal, such changes will tend to lead to an appreciation of that economy’s nominal exchange rate. Similarly, an economy in which demand is strong relative to its productive capacity will, other things equal, experience an increase in its real exchange rate. This can occur via an increase in inflation of wages and prices, or in a more timely way via a nominal appreciation. Changes in unemployment rates across countries can provide a rough gauge of these relative demand pressures. Following the onset of the global financial crisis, growth in Australia slowed and the unemployment rate increased, but nowhere near the extent experienced by most advanced economies that were in the throes of deep recessions. So from 2007 to late 2010, the unemployment rate improved in Australia relative to that of the major advanced economies. While Australia’s terms of trade increased further over this period, the relative strength of Australia’s economy, as evidenced by relative unemployment rates, was also consistent with an appreciation of the Australian dollar. However, growth in Australia began to slow from early 2012. The transition from the investment to the production phase of the resources boom has contributed, in part, to growth slowing to a below-trend pace over the past year or so, where it is expected to remain for a BIS central bankers’ speeches time. Meanwhile, prospects for growth in many other advanced economies have improved. Accordingly, the gap between unemployment rates that had opened up earlier declined from 2011 onward. In short, looking at the performance of the Australian economy relative to that of other advanced economies tells a similar story to that which I described using the model based on the terms of trade and the interest rate differential. Namely, the relative strength of the Australian economy for a time following the onset of the global financial crisis was broadly consistent with an appreciation of the Australian dollar, but that situation turned around sometime in 2011, suggesting that the exchange rate might have depreciated somewhat earlier than it did. Why the model/history might be a less useful guide this time around My earlier discussion of the model estimates suggested that it is hard to be very precise about whether the level of the exchange rate is in line with fundamental determinants. To emphasise this point, let me come back to the effect of the resources boom on the exchange rate. It is possible that history (including that embodied in the model estimates) is less useful as a guide for this current resources boom. One point of difference is the share of foreign ownership of the resources sector. While it is difficult to get reliable estimates of this share, it appears to have increased over time.13 This means that less of the extra revenue associated with both existing and new resource ventures will accrue as profits paid to Australian residents than might have been the case in earlier booms.14 Another point of difference with this episode is that liquefied natural gas (LNG) projects will account for a large share of the additional production and exports generated by the boom in investment. By some estimates, LNG exports will rise from less than half the value of coal exports currently to be worth more than coal exports in only a few years (Table 1). While LNG projects require a substantial number of Australian workers to help put the new extraction, processing and transport facilities in place, they require relatively few workers during the production phase.15 This means that less revenue from the sale of resource exports will accrue to Australian residents in the form of wages than would have been the case if more of the investment had been focused on other commodities. Some estimates highlight the fact that foreign ownership of LNG projects is higher than it is for iron ore and coal, and we know that LNG accounts for a very large share of resources investment and is going to account for a substantial and increasing share of export revenues (see Connolly E and D Orsmond (2011), “The Mining Industry: From Bust to Boom”, RBA Research Discussion Paper No 2011–08). Similarly, about half of resources investment over the past decade has been undertaken by foreign companies (see Arsov I, B Shanahan and T Williams (2013), “Funding the Australian Resources Investment Boom”, RBA Bulletin, March, pp 51–61). The difference in the ownership structure is even starker when comparing this episode with earlier times when the rural sector played a prominent part in commodity booms. During the Korean War, the sectors benefiting from higher wool prices were largely, if not entirely, owned by Australian residents, and were relatively intensive in their use of labour; although this episode falls outside of the sample used to estimate the model. As a rough guide, the construction of an iron ore or coal mine typically requires around two to three times as many workers as are ultimately required to operate the mine. For a typical Western Australian LNG project, the ratio is close to 10:1 (Department of Mines and Petroleum (2013), “Significant Resource Projects in Western Australia” <http://www.dmp.wa.gov.au/documents/Prospect_September_2013.pdf>, Prospect, September, p 32; Resources Industry Training Council (2010), Western Australian Gas and Oil Industry: Workforce Development Plan <http://ritcwa.com.au/LinkClick.aspx?fileticket=oH5bC1PV7aA%3D&tabid=133>, November). Unlike in Western Australia, Queensland’s LNG projects draw on coal seam gas, which will be supplied by thousands of wells drilled over the life of the projects. This drilling program will require an ongoing investment and sustain a sizeable upstream workforce. BIS central bankers’ speeches Either of these possibilities would suggest that a model linking the exchange rate to the terms of trade based on earlier experiences might overstate the “equilibrium” level of the exchange rate during this episode. That is, the “equilibrium” rate shown in Graph 4 might be overstated. Working in the other direction, however, there are reasons to think that the “equilibrium” rate in the model might have been understated over recent years. One reason for a bias in this direction is the effect of the balance sheet expansions by the central banks of the major advanced economies.16 The US Federal Reserve and the Bank of Japan took these actions in response to the weak state of demand in their respective economies. The expansions of their balance sheets have for some time worked to reduce yields on financial assets in these economies. One consequence of this is that the value of their currencies is likely to have been lower than would otherwise have been the case. The fact that these expansions have been occurring for some time suggests that they may have been placing some upward pressure on the Australian dollar in the years following the onset of the global financial crisis. The fact that they are still playing out may have continued to provide some support to the Australian dollar beyond the time at which the terms of trade and the interest rate differential had begun to decline. Nevertheless, the Fed signal earlier last year that tapering (i.e. the scaling back of the extent of its asset purchases) might not be too far away may have helped to bolster perceptions that the outlook for growth in the United States was improving. This would also imply an improvement in returns to US assets. Such a change in views, when combined with the existing influence of the decline in our terms of trade and the interest rate differential, may have helped to trigger the depreciation of the Australian dollar from earlier last year. Conclusion Let me conclude by drawing together some of these threads. In theory at least, markets for foreign exchange should already embody all relevant available information about current and future demand for currencies. While exchange rates will respond to (as yet unknown) developments, it is hard to know with any certainty today what exchange rates will do in the future. See, for example, Reserve Bank of Australia (2014), Statement on Monetary Policy, February. BIS central bankers’ speeches Having said that, there are times when the exchange rate does not move in line with what the historical behaviour of fundamental determinants would otherwise imply. This suggests that a correction in the exchange rate might be in prospect. However, assessing how much weight to give to different determinants, and determining when any correction might occur, is subject to considerable uncertainty. There were good reasons to think that the Australian dollar has for the past couple of years been on the high side of fundamentals. In particular, the decline in the terms of trade from late 2011 and the transition from the investment to the production phase of the mining boom imply lower returns to capital in Australia and a lessening of demand for Australian factors of production relative to the rest of the world. Moreover, the decline in mining investment means that a decline in an important source of capital inflow over recent years is in prospect. Given all of this, it was not so surprising that the Australian dollar has declined over the past year. In the same vein, it was somewhat surprising that the exchange rate had not depreciated earlier. However, it may have been that more tangible signs of improved prospects for growth in a number of advanced economies, particularly in the United States, helped to spur on the depreciation of the Australian dollar. The Bank has noted for some time that lower levels of the exchange rate, if sustained, will assist in achieving balanced growth in the economy and bring about a quicker return to trend growth. It will also add a little to inflation, for a time. On present indications, inflation is expected to be somewhat higher than we’d thought in November, in part because of the further depreciation since then, but it is still expected to remain consistent with the inflation target. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 2 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 7 March 2014. | Glenn Stevens: Australia’s economy against the background of recent international developments Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 7 March 2014. * * * Madam Chair Members of the Committee Thank you for the opportunity to meet with you today. When we met with the Committee just prior to Christmas, I suggested that, taking an international view, 2013 could be described as a year that turned out not to be quite as good as hoped for, but not as bad as feared. Nothing that has occurred in the period since then would change that assessment. One prominent international event was that, within hours of that hearing, the US Federal Reserve commenced the “tapering” of its monthly asset purchases. This was a possibility we talked about at the time and, although the timing of it wasn’t known, it was considered likely that it would begin before long. A further reduction in asset purchases was decided at the Fed’s January meeting. After all the anticipation of this change, the actual announcement of the Fed’s decision caused little disruption in markets in December. During January there was more volatility in markets, and a few emerging economies came under pressure, with bond yields spiking and exchange rates declining. It is important to keep this in perspective. Periods surrounding changes of course by the Fed have often been times when market participants re-assess their positions and their appetite for risk, and this occasion has been no exception. It isn’t necessarily the Fed action per se that is most important, but rather what it conveys about the overall economic and financial environment. At such times investors sometimes start to focus on risks to which they had hitherto been attaching little significance. Investors have not, however, fled from risk indiscriminately on this occasion, at least to date. They have drawn distinctions between alternative classes of investment and different countries. Long-term sovereign yields of the core advanced countries have increased a little, but they remain low. With compressed risk spreads, this means that borrowing costs for many private-sector borrowers remain very low. The spreads over German yields for European sovereigns have continued to fall. This suggests that actions by European policymakers have had more influence on European markets than actions by the US authorities. This is as one would expect, but it hasn’t always been the case in the past. Moreover, not all emerging markets are experiencing the same pressure. Some that experienced considerable turbulence in the middle of last year, when tapering was first mooted, have seen less of that recently. This owes something at least to policy responses in those countries in the intervening period. Among those countries that have been under most pressure of late, genuine domestic sources of risk can be observed in most instances. In several cases the market pressure has resulted in policy responses, which were perhaps needed anyway. In general then, tapering is proceeding, so far, about as well as can be expected. In the meantime, forecasts for the global economy haven’t changed much in recent months. If anything they have inched higher. They suggest that 2014 growth will be higher than in 2013, and at about average pace. More of the growth is coming from the advanced countries, and proportionately not quite so much from the emerging ones. That, too, is BIS central bankers’ speeches probably a welcome re-balancing in some respects after the weakness of the advanced countries in recent years. Australia’s terms of trade have been little changed over the past year, though we still assume they will decline further in the future. Turning to the Australian economy, for some time our view has been that growth has been running below its trend pace. The national accounts released a couple of days ago don’t significantly change that assessment. For the year to the December quarter of 2013, real GDP rose by about 2¾ per cent. This is roughly in line with the forecasts we have had for a while. The drivers of growth are shifting. As we have been saying for some time now, and as confirmed in the recent survey of capital expenditure intentions by firms, the very high level of investment spending by mining companies has turned down, and the decline will accelerate over the coming year. Other areas of demand will provide at least some offset. Export volumes for resources are growing strongly, as the capacity that has been put in place by the high levels of investment comes on line. For example, iron ore shipments have risen by about 85 per cent from their levels of five years ago, to around 1.5 million tonnes per day. They will rise further over the coming year or two. It is clear that dwelling investment activity will rise strongly over the period ahead. Over the past three months, approvals to build private dwellings numbered almost 50,000. That is an increase of about 27 per cent from the figures of a year earlier, and is the highest threemonth total in the 30-year history of this series. Consumer demand has had a firmer tone over the summer, after a fairly lengthy period of more subdued outcomes. This is evidence in the retail trade and national accounts data and is confirmed in information from the Bank’s liaison. Consumer sentiment does still seem a little skittish, though, and while we expect consumption spending to grow in line with income or perhaps a little faster, consumers are unlikely to be the drivers of growth that they were prior to the financial crisis. Business investment spending outside mining, which has been very low indeed, is bound to pick up at some stage. The signs of improved conditions and confidence that we have observed in some sectors will help, and the early indications of an improvement in capital spending expectations are apparent. Those are, however, quite tentative at this point and firms are looking for recent signs of improved conditions to persist before committing to expanded investment spending. Public final spending is scheduled, according to the announced plans of federal and state governments, to be quite weak. The expected ongoing effects of very low interest rates and a somewhat lower exchange rate have resulted in a slight lift in forecast growth for the second half of this year and in 2015. This was reflected in our most recent published forecasts released last month. We haven’t made any further changes since then. With growth having been below trend, job vacancies declined, employment growth weakened and unemployment rose in 2013. Some forward indicators have stabilised and then improved a little of late, which is promising. But even with this, and with a slightly better growth outlook, the labour market will probably remain soft for a while yet, given that it lags changes in activity. This has seen the pace of growth of wages decline noticeably. Turning to consumer price inflation, the recent data show inflation in underlying terms at about 2½ per cent over the course of 2013, and a pace higher than that in the second half of the year. This is a change from the middle of last year, when we were receiving data that were lower than expected. Part of the increase in inflation is explained by the effect of the depreciation of the exchange rate, which has resulted in increases in prices of traded goods and services. But that does not account for all the result and it is, at least on the surface, something of a puzzle that underlying inflation moved up while growth in labour costs moved down. There may be a rebuilding of margins in some areas, particularly those where demand conditions have BIS central bankers’ speeches improved a little from the very weak situation earlier. There may also be an element of noise in the quarterly data. The view we have taken, pending further evidence, is that there is probably both noise and signal in the result. Hence, our assessment is that inflation is not quite as low as it might have looked six to twelve months ago, but nor is it accelerating to the extent a literal reading of the latest data might suggest. The general situation – 18 months of below-trend growth, a rise in unemployment, a marked slowdown in wages – is not one that would be obviously associated with a sustained rise in price pressures. Our view remains that the outlook for inflation, while a little higher than before, is still consistent with the medium-term target. Monetary policy is very accommodative. The cash rate has been unchanged since August last year. It and most borrowing rates are at multi-decade lows. The sorts of things that are normally expected to result from low interest rates are increasingly in evidence: • savers are looking for higher return assets as the yield on safe assets has fallen • asset prices have risen • credit growth has picked up somewhat for households, and particularly for investors in housing, where it is running at an annualised pace of close to 9 per cent • construction of dwellings is set to rise, probably quite strongly • liaison suggests that lenders are becoming more accommodating to potential business borrowers and few complain about availability of credit • the exchange rate has depreciated, though it is still high by historical standards. On the whole, then, accommodative monetary policy is playing its part in supporting sustainable growth in demand, consistent with the inflation target. Of course, the outlook contains many uncertainties, not least the ‘hand over’ from mining investment spending to sources of demand outside mining. In some important respects, the basis for such a handover is coming into place, as I have just described. The question then is: will the additional demand likely to be generated outside mining as a result of these trends be just the right amount to offset the large decline in mining investment spending, so keeping the economy near full employment? No-one can answer that question with great confidence. Moreover, even if it were possible for forecasts to be much more accurate than experience could possibly lead us to hope, it could not be assumed that a shortfall in demand could necessarily be made good in short order by monetary policy. Monetary policy can have a powerful effect on the general environment, but it cannot hope to fine-tune the quarterly or even annual path of aggregate demand. At the present time we judge monetary policy to be doing the things it can reasonably be expected to do in the circumstances we face. We have signalled the likelihood, if the economy evolves more or less as expected, of a period of stability in the cash rate. As well as the low level of interest rates generally, a sense of stability should be of some help for businesses and households as they form their plans. My colleagues and I are here to respond to your questions. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 3 |
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to The Sydney Institute, Sydney, 12 March 2014. | Philip Lowe: Demographics, productivity and innovation Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to The Sydney Institute, Sydney, 12 March 2014. * * * I would like to thank David Jacobs, Michelle Bergmann and Daniel De Voss for excellent assistance in the preparation of this talk. Thank you very much for the invitation to address The Sydney Institute. Over many years, the Institute has played an important role in the intellectual and public policy life of our city and our country. It is, therefore, a very real honour to be here. The title of my remarks is Demographics, Productivity and Innovation. What I would like to do this evening is to step back from the constant flow of high-frequency data on the Australian economy and explore a longer-term issue – namely the potential links between demographic developments, productivity growth and our society’s attitudes to risk and innovation. To try to make these issues a little more concrete, could I begin by asking you to think about two questions: How has our society’s attitude to risk and innovation evolved over time and what implications are there for productivity growth? As the population ages, how might our attitude to risk and innovation continue to change? These are not easy questions to answer. Understanding how people think about risk and what drives productivity growth are issues that the economics profession has struggled with for many years, with robust answers difficult to come by. As a result, some of what I have to say this evening will inevitably be speculative, and for a central banker that is a slightly uncomfortable thing to do! Nevertheless, these questions are worth thinking and talking about. Western societies are ageing and productivity growth in many advanced economies has trended lower for some time now. In addition, over recent years, businesses and households in many countries seem to have become more risk averse. The proximate cause of this has been the financial crisis, although I suspect that there might also be deeper factors at work. These developments rightly throw the spotlight onto the issues of how our society generates and funds the innovations that are so important for continued improvement in our living standards. These issues might seem quite a long way from the short-term setting of the cash rate, which is the main task that keeps the Reserve Bank in the news. But understanding them is critical to doing our job well. Demographic trends and productivity growth are central to understanding how fast the economy can grow without inflation exceeding the medium-term inflation target. And while changes in demography and productivity have little influence on our month-to-month decisions about the cash rate, they do have an important bearing on the average level of the cash rate over time. In effect, they set the contours within which we make our monthly decisions. So this evening, I would first like to talk about recent demographic trends in Australia and compare those with what is happening in other advanced economies. I would then like to talk about the productivity challenge that lies ahead and the importance of a culture that promotes innovation. And finally, I would like to link the demographic trends to this productivity challenge. BIS central bankers’ speeches Demographic trends First, to demography, which, in my view, we do not talk about enough. Mostly, demographic developments are not deemed to be newsworthy. And in the financial markets, the impending release of demographic information is not met with the same excited anticipation that sometimes accompanies the release of the latest monthly statistics. Yet, demographic developments have profound effects on our economy and on our society. I would like to draw your attention to three specific developments in Australia. The first is that our population is growing pretty quickly, and has been for some time. Over the past five years, the population has increased by 9 per cent and it is projected to grow by another 9 per cent over the next five years. The rate of natural increase has tended to slow a little over recent decades, although this has been more than offset by a pick-up in the rate of immigration (Graph 1). The result has been the fastest rate of population increase in more than three decades. Graph 1 Most other developed economies find themselves in a very different position, with the rate of population growth in the OECD, as a whole, only around one-third of that in Australia (Graph 2). Indeed, our population has been rising at a faster rate than the population of almost any other country in the OECD. In a number of these countries, the population has actually been declining over the past few years and the rate of decline is expected to accelerate. Japan is perhaps the most prominent example here, with the population projected to fall by 10 per cent over the next 20 years, while the working-age population is projected to fall by an almost unprecedented 17 per cent over this same period.1 These are remarkable numbers. See National Institute of Population and Social Security Research (2012), “Appendix: Auxiliary Projections 2061 to 2110” in Population Projections for Japan (January 2012): 2011 to 2060, January. Available at http://www.ipss.go.jp/site-ad/index_english/esuikei/gh2401e.asp. BIS central bankers’ speeches Graph 2 The second aspect of our demography that I would like to draw your attention to is the diversity of our population. According to the latest estimates, 28 per cent of Australia’s current population was born overseas (Graph 3). This share has been steadily rising since the 1940s and is currently at its highest level since the late 19th century. This share is also very high by international standards; in most countries, immigrants account for less than 15 per cent of the population, and in quite a few cases the figure is in the low single digits (Graph 4). Among the larger advanced economies, only Switzerland has a higher share of immigrants in the population. It is also worth noting that, on average, new immigrants to Australia are almost 10 years younger than the average Australian. Immigrants are also more likely to have a post-secondary school qualification than the average Australian. Graph 3 BIS central bankers’ speeches Graph 4 The third aspect of our demography is the ageing of the population. For most of the past 40 years or so we have had somewhat of a demographic dividend. While the share of the population that is over 65 has been steadily rising, this has been more than offset by a decline in the share of children in the population (Graph 5). As a result, the share of the working-age population – defined here as those between 15 and 64 – has trended higher. However, this trend has now turned around and the share of the population in the 15–64 age group is in decline. Graph 5 BIS central bankers’ speeches We are starting to see the effect of this demographic transition in the monthly employment data. For many years, the participation rate – that is, the share of the adult population in the labour force – had been steadily rising. In contrast, over recent years, the participation rate has declined and today it is around the same level it was in 2006. Part of this decline is cyclical, reflecting the current soft conditions in the labour market. But our analysis also suggests that around half of the decline since late 2010 is due to ageing, which is more structural in nature. The results of this analysis can be seen in Graph 6, which shows the actual participation rate (the orange line) along with our estimates of how the participation rate would have evolved had the age structure of the population been constant over time (the blue line). Given the ageing that is taking place, these data imply that the participation rates for the various age groups will need to continue to increase if the overall participation rate is to trend higher again. Whether or not this happens will have an important bearing on the future growth rates of our economy. Graph 6 Australia is, of course, not unique in having to deal with the challenge of an ageing workforce. Indeed, the changes taking place in a number of other advanced economies are much starker than those that are taking place here (Graph 7). Our relatively high population growth, which includes a flow of relatively young immigrants, means that a number of countries in Western Europe as well as Japan and South Korea are further along in this journey than we are. From our perspective, this provides us with an opportunity to learn from their experiences. BIS central bankers’ speeches Graph 7 So in summary: our population is growing rapidly, it is increasingly diverse and it is getting older. I will return to these themes in a few moments. But before I do that, I would now like to turn to the issue of productivity. Productivity and innovation As I have spoken about before, Australia faces a major challenge here.2 Looking back over the past two decades or so, we have enjoyed faster growth in real per capita income than almost any other advanced economy. In the 1990s, we benefited from strong productivity growth. Then in the 2000s, our collective living standards were boosted by a very large rise in commodity prices. And over much of this period our national income was further increased by the rise in the labour force participation rate that I mentioned a moment ago. Today things look a little different. Productivity growth over the past decade has been lower than it was in the 1990s, commodity prices are high but no longer rising, and the share of the population in employment has fallen recently. If these trends continue we face the prospect of considerably slower growth in our living standards than we have become accustomed to. The solution here is to lift our productivity growth. Again, Australia is not the only country facing this challenge; in almost all developed economies, productivity growth has been slower over the period since the mid 2000s than it was over the preceding decade (Graph 8).3 There is much debate about why this is the case. One line of thought is that the slowdown is largely a legacy of the financial crisis, which, among other things, caused investment spending in many advanced economies to fall to very low levels. See Lowe P (2013), “Productivity and Infrastructure”, Speech to the IARIW-UNSW Conference on Productivity Measurement, Drivers and Trends, Sydney, 26 November. This is true of both labour productivity and multifactor productivity growth. BIS central bankers’ speeches Graph 8 Another line of thought is that the slowdown is much more structural in nature. A prominent advocate of this view is Professor Robert Gordon from Northwestern University. He argues that the first three-quarters of the 20th century was a golden period in terms of productivity growth for the advanced economies. During that period, we worked out how to take full advantage of the transformational inventions of electricity and the internal combustion engine that occurred at the end of the 19th century.4 While there have been many breakthroughs over recent years, Gordon argues that they pale into insignificance compared with the huge advances made possible by these iconic inventions at the end of the 19th century. Another sombre assessment is offered by Nobel Laureate Edmund Phelps. He argues that the problem is not so much that we have run out of really great things to invent, but that western societies are now less able to invent them. He argues that cultural changes, including the changed role of government, have stifled the desire and incentives for innovation. As a result, our economies have become less dynamic and less likely to find, develop and make use of the major technological breakthroughs that are the source of much productivity growth.5 As is usual in economics though, there is a counterview and it is much more optimistic. This view is that the so-called techno-pessimists are fundamentally wrong and, rather than facing a future of much slower technical progress, we are on the cusp of a new era of great progress in science. A prominent advocate of this view is Robert Gordon’s colleague at Northwestern University, Joel Mokyr, who argues that the technological advances of recent times have given scientists a dazzling new range of tools and instruments. These advances have also greatly lowered the cost of accessing information. His argument is that, as a result, a new age of great scientific advancement is now possible.6 See Gordon RJ (2012), “Is US Economic Growth Over? Faltering Innovation Confronts the Six Headwinds”, NBER Working Paper No 18315, August. Available at http://www.nber.org/papers/w18315. See Phelps E (2013), Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change, Princeton University Press, Princeton. See Mokyr J (2013), “Is Technological Progress a Thing of the Past?”, EU-Vox essay, 8 September. Available at http://www.voxeu.org/article/technological-progress-thing-past. BIS central bankers’ speeches I don’t profess to know which of these views is correct – only time will tell. What underlies these debates though is that the ability of a society to innovate, to take and manage risks and to respond quickly to the changing world helps determine the rate of productivity growth. Improvements in productivity require existing resources to be used more efficiently or advances in technology – they do not occur from doing the same thing over and over again without change. So if we are to improve efficiency and advance technology then innovation is required and innovation requires someone to take a risk – the risk of trying a different process, the risk of changing workplace organisation and management practices, or the risk of spending scarce resources to explore a new idea. Sometimes the effort will not pay off, but just occasionally it will, and when it does, we find a better process, a more efficient organisational design or an idea that transforms how we do things. The point I want to emphasise here is that regardless of whether the techno-pessimists or the techno-optimists turn out to be correct, our attitudes to risk-taking, to innovation and to entrepreneurship have a significant influence on our future living standards. At this point, I would like to return to one of the questions I asked you to think about at the beginning: how has our society’s attitude to risk and innovation evolved over time and what are the implications for productivity growth? My own tentative answer is that there has been a subtle, but important, shift in the way we think about risk and innovation. In particular, our preferences appear to have shifted in such a way that we increasingly focus on risk mitigation and risk control. There are examples of this in a whole range of activities in our society – from the nature of the legislation that parliaments pass, to the increase in compliance activities in the nation’s boardrooms, to the amount of money we are prepared to spend to limit the probability of blackouts and even to our attitudes about the design of children’s playgrounds. In each of these areas, our society has been prepared to limit options or to spend more of our scarce resources to reduce risk. I want to make clear that I am not saying that this is necessarily a bad thing. Wealthy societies like our own have considerable capability to address risks in a way that poorer societies cannot. After all, that is one of the benefits of economic progress. And it may also be the case that wealthy societies inherently have less tolerance for certain types of risk than do less wealthy societies. So what we are seeing may well be optimal from the perspective of our collective welfare, even if it does not maximise measured economic growth. But, at least in my opinion, it is appropriate occasionally to ask whether we have got the balance right. Reducing risks is not always cost free – resources need to be devoted to the task and this means that these resources cannot be used for other tasks. And perhaps even more importantly, it might also be the case that a more risk-averse society is naturally less inclined to support and finance innovation, to implement new processes and to apply new technologies. If this is indeed the case, it has implications for future productivity growth. Here, I want to circle back to the issue of demography, because some of the developments that I spoke about earlier have the potential to shape how our society thinks about risk, innovation and change in the future. You might recall the second question I asked: how might society’s attitude to risk and innovation change as a result of ageing of the population? Again, there are no definitive answers. Older workers do have considerable accumulated experience that can boost their productivity. However, the available data both in Australia and the United States suggest that individuals in their 30s and 40s have a higher probability of becoming an entrepreneur than do older individuals.7 The take-up rate for new See Australian Centre for Enterprise Research (2012), “Global Entrepreneurship Monitor, National Entrepreneurial Assessment for Australia – GEM Australia 2011 National Report”, Queensland University of Technology, available at http://www.gemconsortium.org/docs/download/2414 and Reynolds P and BIS central bankers’ speeches technologies is also higher for younger workers. In addition, younger people tend to be less risk averse than older people in their financial decisions.8 All else constant, this higher risk aversion of older citizens means that as the population ages, access to capital for more risky firms, especially start-ups with little business history, is likely to be more restricted and more expensive. There are, of course, also factors working in the other direction. As the workforce ages, the incentive to find new labour-saving techniques is likely to increase. And the rising pressure on public finances from the ageing of the population should increase the incentive for governments to find more efficient ways of delivering goods and services. So it is not yet possible to know what the net effect of ageing will be on our attitude to risk and innovation. But, if ageing societies do become inherently more risk averse and less supportive of innovation – as I suspect they might – then we are likely to face a greater challenge than we have to date in generating productivity growth. This means there is likely to be more of a premium on getting policies right in some key areas related to innovation. I would like to mention five of these, although they are by no means exclusive:9 The way in which we finance innovation, including the access to start-up capital for new businesses. The Financial Sector Inquiry will no doubt look at this issue. The incentives for innovation that we establish through the tax system. The way we support human capital accumulation and research. Our business culture and the way we promote and support entrepreneurship. The way in which we promote competition in our markets, for it is often competition, or the threat of it, that is the driver of innovation. These are all challenging areas to get right and they should all be on our collective radar screen if we are to maintain and strengthen the culture of innovation in an ageing society. I would also like to briefly return to the two other demographic factors that I mentioned earlier, because I think there is a more positive story here. In particular, a reasonable case can be made that both of these demographic factors – that is fairly fast population growth and the increasing diversity of our population – can actually promote innovation. If the population is growing quickly, then the overall size of the market is getting bigger every year. This dynamism creates new opportunities and can increase the pay-off from taking a risk. And the increasing diversity of our population means that we have a constant influx of people coming to our shores, bringing with them new perspectives, new skills and new ideas. While high population growth and high levels of immigration can create challenges of their P Davidsson (2009), “PSED II and the Comprehensive Australian Study of Entrepreneurial Emergence (CAUSEE)”, in P Reynolds and R Curtin, New Firm Creation in the United States: Initial Explorations with the PSED II Data Set, Springer, pp 265–280. Data from the Household, Income and Labour Dynamics in Australia (HILDA) survey indicate that individuals over the age of 65 are more likely to report that they are not willing to take financial risks, and less likely to report that they are willing to take above-average financial risks, when compared with the rest of the population (see Black S, L Rogers and A Soultanaeva (2012), “Households’ Appetite for Financial Risk”, RBA Bulletin, June, pp 37–42). See Banks G (2012), ‘Productivity Policies: The “To Do” List’, Speech at the Economic and Social Outlook Conference, “Securing the Future”, Melbourne, 1 November. Available at http://www.pc.gov.au/__data/ assets/pdf_file/0009/120312/produtivity-policies.pdf; Daley J, C McGannon and L Ginnivan (2012), “Gamechangers: Economic Reform Priorities for Australia”, Grattan Institute, Melbourne. Available at http://grattan.edu.au/static/files/assets/bc719f82/Game_Changers_Web.pdf; and Department of Industry (2013), Australian Innovation System Report, Department of Industry, Canberra. Available at http://www.innovation.gov.au/science/policy/AustralianInnovationSystemReport/AISR2013/wpcontent/uploads/2013/11/AIS-Innovation-Systems-Report-2013-v3.pdf. BIS central bankers’ speeches own, properly managed, they can also help create a more dynamic economy and a society with more opportunities for all. So there is a reason for optimism here. In a number of areas, Australia’s demographic trends are more favourable than in most other western countries. We have a strong record of adapting to change and allowing the marketplace to guide our adjustment. Our sound macroeconomic and financial frameworks also provide a basis for confidence. The challenge we face is to build on these advantages and to strengthen our collective ability to innovate and to adjust to the changing world. We will need to do this if we are to enjoy the type of growth in our living standards that we have become used to over the past 20 years or so. Thank you for your time this evening. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 3 |
Address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the CFO Summit 2014, Gold Coast, 16 March 2014. | Malcolm Edey: Reflections on the financial crisis Address by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the CFO Summit 2014, Gold Coast, 16 March 2014. * * * Thank you to our hosts for the opportunity to speak here today. I have called this talk “Reflections on the Financial Crisis”. That might seem like a somewhat dated and backward-looking focus. After all, it is now roughly seven years since the early signs of trouble in the US sub-prime mortgage market first came to general attention, in the early part of 2007. It is 5½ years since the failure of Lehman Brothers brought the crisis to its most severe phase. And it is almost exactly five years since the markets and economies that were worst affected began their gradual path to recovery. Five years is a long time in economics. But one of my themes today is that financial crises are costly events, and one of the reasons they are so costly is that their effects can continue long afterwards. The after-effects of the latest crisis are still with us and, I expect, will continue to shape the business environment for some time to come. It needs only a few facts and figures to convey the impact of the crisis at its height. In the world’s largest economy, national income and output fell by about 4 per cent over the year to June 2009. That made it by far the sharpest US recession of the post-war period. In the euro area the peak-to-trough fall in output was even larger at around 6 per cent, and in the UK it was 7 per cent. These are big numbers when you remember that in Australia’s most recent recession, in 1991, output fell by less than 2 per cent. The contractionary effects around the world were particularly concentrated in trade and industrial production. Some of the economies in the east Asian region posted declines in those variables of the order of 30 per cent in the space of just a few months in late 2008. And of course financial markets were severely affected. Global equity prices fell by around 40 per cent and there was a major dislocation in debt markets. On all of these counts, the recent crisis was certainly the most severe since the Depression, and in that sense it might be thought of as the kind of once-in-a-lifetime event that helps to define an epoch. That background suggests a number of interesting questions that I want to think about today: • Why was the latest crisis so severe? • What does history teach us about the risk of it happening again? • In what ways are the after-effects of the GFC still continuing? • And what will the crisis mean for the way central banks do their jobs? Let me take those questions in turn. Why was the latest crisis so severe? There have been many “post mortem” efforts to analyse the causes of the GFC and the severity of its effects.1 Generally speaking, they focus on two lines of explanation. See for example, Financial Stability Forum (2008), “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience”, 7 April. BIS central bankers’ speeches The first stresses the factors that are common to all financial bubbles: the combination of cheap credit, leverage, rising asset prices (especially in real estate) and increased appetite for risk; and of course, the perception that “this time it’s different”. All of these elements were present in the lead up to the GFC. And, as in earlier cases, there was at least some rationale for the initial exuberance. There were credible arguments, for example, that business cycle risks had been genuinely reduced.2 Some thought that this could justify an increased appetite for risky assets. The second line of explanation focuses on the distinctive risk factors that came to the fore in the GFC and made this financial cycle different from others. They included the expansion in US sub-prime lending in the decade leading up to the crisis, the subsequent downturn in the US housing market and the resultant collapse in markets for mortgage-backed securities. Contagion was amplified by exposures to over-engineered securities of dubious value, and by a range of poor risk management and governance practices associated with all of that. We all remember the CDOs (collateralised debt obligations) that were marketed as highly rated securities but turned out to be largely worthless. These initial asset quality problems then exposed other weaknesses that led to institutional failures and the international collapse in confidence. This story has been well told. Every crisis, of course, has its own particular pathology but that fact in itself doesn’t explain their relative impacts. Why was this one so much more severe than most of the others? I can think of at least three reasons why that might have been the case. One is the presence of a common driver affecting asset values and financial systems in multiple countries at once. Many would view the low interest rate environment that prevailed around the world in the pre-crisis years as a key driver in that regard. This was itself a function of deeper factors that were much debated at the time, including what some saw as a global “glut of saving” along with concerns about deflation risks following the collapse of the earlier tech bubble. I won’t go into that debate today other than to note the consequences. Periods of low interest rates are not uncommon, but what was unusual in this case was its persistence across large parts of the world. While not making a crisis inevitable, it contributed to simultaneous risktaking and hence vulnerabilities in a number of the major economies. Another factor is the increasing size and complexity of financial systems. It has been a general pattern, at least within the post-war period, that financial systems have tended to grow faster than the economies that they service. There are some good reasons to expect this to be the case. As societies get richer, the proportion of income that people are prepared to spend on financial services tends to rise. At the same time, technological progress supports innovation and new forms of financial risk-taking. The result is a general trend towards financial deepening as economies develop. In 2006 the outgoing Reserve Bank Governor Ian Macfarlane made the prediction that these factors would change the nature of the business cycle. In particular he expected that future cycles would be driven more by financial events than by the shocks to demand and spending that had predominated in the post-war period to date. It was a prescient observation, coming not long before the onset of the GFC.3 A third factor is that this has really been two separate crises joined together. There was a crisis of asset quality, financial over-engineering and leverage driven by the forces that I have already described. But there was also a crisis of confidence in the stability of the euro See for example, Bernanke BS (2004), “The Great Moderation”, Remarks at the meetings of the East Economic Association, Washington, DC, 20 February. Macfarlane IJ (2006), The Search for Stability, Boyer Lectures 2006, ABC Books, Sydney. BIS central bankers’ speeches as a single currency area. The first one triggered the second, but the euro area vulnerabilities were already present for reasons unconnected to the origins of the GFC. Observers had previously questioned whether the euro area had the necessary governance arrangements to ensure resilience. At heart the question was whether a currency union could be robust to shocks without fiscal and banking union, or at least without appropriate coordination arrangements in those areas to ensure that stress events could be managed. The effect of the GFC was to put that to the test. By the second half of 2009 the US economy was clearly recovering from the initial crisis impact, and US authorities had taken a number of steps to repair damaged banks. But, initially at least, the strains in European markets intensified further. These strains culminated in the Greek sovereign debt crisis, along with severe pressure on a number of the so-called “peripheral” euro area markets in 2010 and the first half of 2011. All of this made it harder for the European economy to recover, which in turn represented a drag on growth for the global economy as a whole. Confidence-building measures are now being put in place and the euro area economy has started to grow again, but all of this takes time. So my candidates for explaining why the GFC was so much more severe than previous crises are threefold: • Correlated risk-taking in a low interest rate environment; • The increased size and complexity of the global financial sector; and • The knock-on effect from the initial crisis to the structural stability of the euro area. What does history teach us about the risk of it happening again? History tells us that financial crises are not new and not particularly rare. In fact, they go back as far as financial activity itself. Historical accounts highlight many colourful examples like the Dutch “Tulipmania” of the 1620s, the South Sea Bubble of 1720, and the UK railway mania of the 1840s. Australia has its own examples, most notably the banking crisis of the 1890s, and we could also include the asset and credit bubble that occurred in the late 1980s. As I have already indicated, there are some common elements to these episodes but each one had its own distinctive mix of greed, dishonesty and collective folly. The general flavour is well captured by the title of Kindleberger’s famous book, Manias, Panics and Crashes.4 These episodes have not been confined to any particular country or region. A recent historical study by the economists Rogoff and Reinhart5 identifies roughly 400 banking crises around the world, of varying degrees of severity, over the past 200 years. They affected countries from all regions, and at a wide range of different stages of development. Evidently there is something in human nature that generates these episodes of financial excess, even though in most cases the impacts have not been as severe or as widespread as those generated by the GFC. This history might lead us into a certain degree of pessimism about the inevitability of future crisis events. But I think that would be the wrong response for a couple of reasons. One is that, despite the summary figures that I have just cited, genuinely significant international crises have been relatively rare. The Reinhart-Rogoff study identifies only six crisis events of international significance in the past two hundred years, and all but one of those were less severe than the GFC. The others were mostly quite localised, both in their causes and their effects. Kindleberger CP (1978), Manias, Panics and Crashes: A History of Financial Crisis, Macmillan, London. Reinhart CM and K Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, Princeton. BIS central bankers’ speeches The second reason is that good policy can make a difference, both to the risk of a crisis and to the severity of its impact. I am often asked why Australia was able to come through the GFC relatively unscathed. Unlike the US, the UK and the euro area, Australia didn’t have a recession and we didn’t have any bank failures. My usual response is that it was a mixture of good luck and good management. On the luck side, we do have the good fortune to be geographically well connected to the fastest growing part of the world economy at a time when its demand for mineral resources has undergone a major expansion. That was undoubtedly a factor in the Australian economy’s general resilience over the past few years. But, without being too triumphalist, there was also the good management side of the ledger. Australia’s monetary and fiscal framework was sound, and it gave us plenty of scope to respond when the crisis hit. Interest rates were at relatively normal levels (actually on the high side of neutral) in the lead up to the GFC. This helped to limit some of the aggressive risk-taking seen elsewhere, and it allowed plenty of room to shift to a more expansionary stance when that was needed. On the fiscal policy front, successive governments had maintained high standards of discipline, and again this allowed plenty of room for expansionary action when needed. At least as important as all this is that Australia was well served by its prudential regulatory framework. The post-Wallis framework that was put in place in 1998 established APRA as the integrated prudential regulator, affirmed the financial stability role of the RBA and set up the Council of Financial Regulators to ensure appropriate coordination among the regulatory agencies. Under APRA’s leadership, Australian banks were held to much higher standards of resilience than many of their international counterparts. The banks remained profitable and well capitalised. Loan performance did deteriorate during the crisis period, but nowhere near as much as it did in the North Atlantic economies. My general conclusion from all of this is twofold: the risk of at least low-level crises is never too far away, so we shouldn’t be complacent; but good policy can make a difference in containing that risk. In what ways are the after-effects of the GFC still continuing? The economic impacts of financial crises can be costly and long-lasting. That is why the risk management effort is so important. The Reinhart and Rogoff study that I cited earlier assembled some interesting data on the size and duration of impacts from financial crises in history. They found that the average duration of impact from a major financial crisis on variables like output and employment was about four to five years. Given that the GFC was a more severe crisis than average it is not surprising, then, that significant effects are still continuing, five years or more after the event. However, the effects have not been evenly distributed around the world. They have been concentrated in the North Atlantic economies and, in important respects, they have been most severe in Europe. I have very few slides in this presentation, but if I had to pick a single chart to illustrate the evolution of these effects it would be the following one (Graph 1). BIS central bankers’ speeches Graph 1 It shows non-performance rates on assets in the major banking systems. The initial deterioration in asset quality was sharpest in the US – not surprisingly, since the crisis originated there. Non-performance rates on US banking assets peaked in early 2010 and there has since been a gradual improvement. The UK experience has been broadly similar except that the peak was higher and came about a year later; but, as in the US, a recovery is now clearly underway. The experience in the euro area has been very different. It was marked by a more gradual initial deterioration but one that is still continuing. Non-performance rates in Europe are now around 8 per cent of loans, higher than the US and UK at their peaks, and still rising. The figures also illustrate the good performance of Australian banks during this period. There are a number of reasons for the contrasting performances of the US and European banking systems. One is that there were more timely and effective corrective actions taken in the US to repair banks’ balance sheets than has been the case to date in Europe, both by government authorities and by the banks themselves. The TARP (Troubled Asset Relief Program) program, the early US stress tests, and various actions to recapitalise troubled banks and dispose of poorly performing assets were all important in this regard. A second reason is one that I have already alluded to. The events of recent years have amounted to a two-stage crisis, and the second stage of it was specifically European (or more accurately, euro area) in focus. The third is the interdependency between growth and financial stability. It is easier for banks to recover in an environment where the economy itself is growing, and in Europe growth has been sluggish at best in the period since the initial downturn. Conversely, it is harder for the economy to grow without a strong banking system. As I have already remarked, this two-way dynamic has been weighing on the euro area for some years. BIS central bankers’ speeches The lingering after-effects of the crisis can be seen not just in the effects on the banks. There are continuing effects on a wide range of economic variables in the major economies. To summarise these I will pick just three: output, employment and government debt. My next chart shows the levels of output and employment in the same set of economies (Graph 2). Graph 2 Again, we see some major ongoing effects from the crisis and the contrasting severity among the four economies that I have focused on. One result commonly seen is that economic recovery following a financial crisis is typically slower than the recovery from an average recession, and that has certainly been the case in this instance. In the United States, GDP regained its 2008 peak level in mid-2011 but growth in the recovery period has generally remained only around trend. This is in contrast to the normal pattern of rapid catch-up seen after earlier recessions. Employment in the US has yet to regain its pre-crisis peak. In Europe, output and employment are still well below pre-crisis levels. Australia, as I have said, didn’t have a recession, with output and employment continuing to expand throughout this period. My third and final chart shows comparative levels of government debt for the same economies, before and after the crisis (Table 1). Not surprisingly we see that debt ratios have substantially increased. The reasons for that are not hard to understand: a combination of automatic fiscal stabilisers as revenues declined when the major economies went into recession; discretionary stimulus measures to counteract the crisis impact; and in some cases, the costs of emergency public support to troubled financial institutions. Once again, I include the Australian data for comparison, and note that the effects here have been relatively mild and come from a favourable starting point. BIS central bankers’ speeches Table 1: Net Public Debt Per cent of GDP (b) US 46.5 87.4 Euro Area 52.1 74.9 UK 38.4 84.8 Australia(a) −3.8 12.1 (a) Financial years 2007/08 and 2013/14 (b) Estimates Sources: Australian Treasury; IMF It is interesting to note that the post-crisis debts ratios in the “north Atlantic major three” have been broadly similar, in the range of 70 to 90 per cent of GDP. The reason the euro area experienced a crisis in its sovereign debt markets was not because of the size of its aggregate debt position per se. It was because of the distribution of that debt, and the associated divergences in economic conditions among the euro area member countries. Nonetheless, the aggregate numbers are high in historical terms and will need to be addressed. One implication of high debt ratios in the north Atlantic economies is that they will face significant pressures for medium-term fiscal consolidation. When coupled with the lingering effects of balance sheet stress and labour market weakness, it seems clear that large parts of the global economy continue to face headwinds to growth more than five years after the peak impact of the crisis has passed. What will the crisis mean for the way central banks do their jobs? One of the further consequences of the crisis has been a rediscovery, or at least a substantial upgrading, of the role of central banks in financial stability policy. Central banks played a crucial part in the initial crisis response by providing emergency liquidity support to institutions and to markets under strain. In many cases they held direct regulatory responsibilities for dealing with troubled institutions, or else cooperated closely with the agencies exercising those powers. And they have played a key advisory role in helping to shape the post-crisis regulatory response around the world. During this period, governments in a number of jurisdictions have taken steps to strengthen the financial stability mandates of their central banks and in some cases have given them additional regulatory powers to that end. I refer to this as a rediscovery rather than an innovation, because in many ways it represents a return to the original rationale for central banking. Central banks are often referred to as “lenders of last resort”. They evolved in 18th and 19th century Europe as a mechanism of liquidity insurance for banking systems that would otherwise have been highly unstable.6 In Goodhart, The Evolution of Central Banks. BIS central bankers’ speeches that way they always had an important role in crisis prevention and crisis management, and it was natural that they took a wider interest in the risk management of the financial system as a whole. It was only in recent decades that some came to see their role as being more narrowly confined to the inflation control function. What we are now seeing, I think, is a better appreciation of the broader original role. How is that playing out in practice? In some cases governments have responded to the lessons of the crisis by transferring significant regulatory powers to their central banks. Perhaps the most prominent example of this is in the UK, where the Financial Services Authority has been made a subsidiary of the Bank of England. Both the US and the euro area have also shifted regulatory powers into their central banks, though within more complex arrangements that are quite distinctive to their jurisdictions. Australia is one of a number of jurisdictions that retains the model of an integrated prudential regulator separate from the central bank. But the Wallis reforms that led to the establishment of APRA still recognised the Reserve Bank’s general mandate to use its powers to promote financial stability. This was more recently emphasised by the incorporation of a section on financial stability into the Statement on the Conduct of Monetary Policy in 2010. Whether or not central banks have formal prudential regulatory powers, they retain an irreducible role in financial stability through their position as managers of system liquidity risk and their associated role in crisis management. What is important is that this function be effectively coordinated with the regulatory policies conducted by the prudential supervisor. This is not the occasion to examine the relative merits of different coordination models in detail. Most likely there are a range of different models that can be made to work, depending on each jurisdiction’s history and legal tradition. Here I simply make the observation that, in Australia’s case, the coordination arrangements held up well during the crisis period. There are a number of mechanisms, both formal and informal, that contribute to this. At the peak level the four main regulatory agencies form the Council of Financial Regulators, chaired by the Reserve Bank Governor. Numerous other coordinating arrangements exist at the staff level. Although the Council is a body without formal powers, it has played an important role in a number of different ways, including information sharing, helping to develop the overall post-crisis response and in making coordinated recommendations to the government. Internationally I find that there is a lot of interest in the Australian coordination arrangements, and it is interesting to observe that a number of other jurisdictions have moved to develop financial stability council structures of their own in the wake of the crisis. Concluding remarks Financial crises are costly. Their effects on the real economy can last a long time. More than five years after the main event, the after-effects of the latest one are still being felt. Large parts of the global economy, especially in Europe, still face headwinds in achieving a return to normal conditions. All of that underscores the importance of better risk management to avoid crises in the future. For regulators, that means holding financial players to better standards of probity and prudence than prevailed in the past. That is what the G20-led regulatory effort is all about. This year, as holder of the G20 presidency, Australia is playing an important leadership role in those efforts. There are also important lessons for the private sector. Excessive leverage is a bad idea. So is investing in complex financial securities where the risk is not properly understood. Banks around the world need better risk management, and stronger capital and liquidity buffers, BIS central bankers’ speeches than they had in the past. It is not just regulators who are demanding this, but shareholders and investors. Expectations about financial sector growth and about sustainable debt need to be realistic. That said, history suggests that crises often have the salutary effect of promoting greater prudence, at least for a while. Hopefully that will be the case this time. The longer the lessons stay learnt, the better will be the prospects for sustained recovery around the world. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 3 |
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the ASIC (Australian Securities and Investments Commission) Annual Forum 2014, Sydney, 25 March 2014. | Philip Lowe: Opportunities and challenges for market-based financing Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the ASIC (Australian Securities and Investments Commission) Annual Forum 2014, Sydney, 25 March 2014. * * * I would like to thank Ivailo Arsov, Mitch Kosev and David Wakeling for valuable assistance in the preparation of this talk. When I was invited to speak at this conference, the ASIC organisers suggested the topic “Opportunities and Challenges for Market-Based Financing”. I was very pleased to be able to accept the invitation as this topic is an important one. It is currently also a highly relevant topic given the Australian Government’s recently commissioned inquiry into the Australian Financial System. I would like to start with a quote from the final report of the previous inquiry into our financial system – the Wallis Inquiry which handed down its findings 17 years ago. In particular, the report observed:1 The evolution of financial systems has been characterised by a continuing struggle between financial intermediaries and financial markets. While the inquiry was wary about making precise predictions, there was quite a strong sense in the report that financial markets would inevitably win this struggle; that over time, markets – including the bond market – would become increasingly important in connecting savers to borrowers. It was thought likely that improvements in technology and access to information would allow better and more differentiated pricing of risk. And that this, combined with increased household savings in superannuation funds and a shift in investment preferences, would give markets the edge over the traditional financial intermediaries, namely the banks. While we have seen some steps in this general direction, including the financing of mortgages through residential mortgage-backed securities (RMBS), things have not exactly turned out this way. Improvements in information technology have greatly improved access to information. However, the challenge turned out not to be so much in accessing the information, but in using the information well. It also turned out that households’ investment preferences did not change that much and that to the extent that they did change, it was mainly reflected in an increased appetite for equities. As a result, while market-based financing has developed over time, it has not grabbed the upper hand as some had thought likely at the time the Wallis Inquiry delivered its final report. One area that has attracted considerable attention is the non-financial corporate bond market. Some commentators have lamented the fact that the Australian market has not developed more rapidly, with most business borrowers still connecting with savers over the balance sheets of financial institutions. Some of these commentators have also lamented the fact that superannuation funds – who they see as a natural buyer of corporate bonds – seem to have had only a limited appetite for these bonds. See Financial System Inquiry (1997), Financial System Inquiry Final Report (S Wallis, chairperson), Australian Government Publishing Service, Canberra, p 159. BIS central bankers’ speeches Given this background, I thought it would be useful to briefly discuss recent developments in the Australian non-financial corporate bond market as well as the role that superannuation funds have come to play in intermediating between borrowers and savers. I would then like to discuss the role that market-based corporate financing can play in providing a form of insurance against stresses in the banking system and the possibility of a lack of competition in the banking system. The Australian corporate bond market By international standards, the Australian corporate sector makes relatively little use of the bond market, especially the domestic bond market. Since the mid 2000s, the available internationally comparable data suggest that average annual bond issuance by Australian corporations has been the equivalent of just under 1 per cent of GDP, with around two-thirds of total issuance taking place offshore, rather than in the domestic market (Graph 1). In most other countries with which we normally like to compare our financial markets, the corporate sector makes greater use of bond funding. Graph 1 The relatively high reliance of Australian issuers on the offshore market is evident in the data on the composition of corporate bonds outstanding (Graph 2). Currently, bonds that were issued offshore account for around 80 per cent of the outstanding value of bonds issued by Australian-based corporations. A decade ago, this figure was considerably lower at around 50 per cent. The offshore market is favoured by companies that want to raise foreign currency funding as a natural hedge against their foreign currency revenue. It has also proven easier to issue large amounts and at longer tenors in the offshore market than it has in the domestic market. BIS central bankers’ speeches Graph 2 Another perspective on recent trends can be gained from looking at the data on the number and credit ratings of the individual bonds that have been issued domestically and offshore (Graph 3). Graph 3 BIS central bankers’ speeches A number of observations stand out: 1. The number of Australian companies issuing bonds is quite small. On average, over recent times, only around 30 bonds have been issued in the domestic market per year, with just a few more being issued in the offshore market. In terms of size, offshore issues tend to be substantially larger and they also tend to have longer maturities. 2. During the global financial crisis, issuance of bonds in the domestic market all but ceased, with only a handful of companies going to the market in 2008 and 2009. During this period, there was some issuance in the offshore market although the number of bonds issued was substantially lower than in the years both before, and after, the crisis.2 This partly reflected the very high spreads being demanded by investors at the time. 3. There was significant issuance of AAA securities in the domestic market prior to the financial crisis, although these securities were credit wrapped by bond insurers. During the crisis most of these insurers were wound down following large ratings downgrades, and this segment of the market has subsequently disappeared. 4. The publically available information indicates that not a single corporate bond with a credit rating below BBB- has been issued in the domestic market. In contrast, since 2000, around 30 bonds rated below BBB- have been issued in the offshore market by Australian corporations. 5. Recently, there has been a pick-up in both the number (and value) of BBB-rated issuers in the domestic market. Last year, a total of 16 BBB-rated bonds were issued, the highest number on record. In another positive sign, the average maturity of these bonds was noticeably longer than in previous years. Putting all this together, the Australian corporate bond market is relatively small in size and is less well developed than corporate bond markets in a number of other countries. Total outstandings in the domestic market amount to around $50 billion compared with total corporate debt outstanding of a much larger $920 billion. Notwithstanding this, regular activity is occurring in the market across much, although not all, of the credit spectrum. And over recent times, issuance appears to have picked up a little, particularly by lower-rated companies. The role of superannuation I would now like to turn to the issue of superannuation funds and their role in the provision of market based finance. This is obviously an important issue given the rising share of national savings being managed by these funds (Graph 4). In the late 1980s/early 1990s, a little less than 20 per cent of the flow of new national savings was being directed into superannuation. Today, the figure is almost double that. The value of issuance in the offshore market increased notably in 2009, primarily due to a small number of large bond issues by major diversified mining companies. BIS central bankers’ speeches Graph 4 According to the latest figures, superannuation funds currently hold around $7 billion of domestically issued corporate bonds (Graph 5). This represents around 15 per cent of the total outstandings in the domestic market, with Australian mutual funds and non-resident investors together holding a further 60 per cent of bonds on issue. All up, domestically issued corporate bonds account for less than 1 per cent of total superannuation assets.3 Graph 5 Superannuation funds also hold some bonds in the offshore market issued by the Australian companies, although comprehensive data are not available. BIS central bankers’ speeches One reason that is sometimes given for superannuation funds’ relatively limited holdings of corporate bonds is that these funds have a strong preference for equities – currently, around 50 per cent of Australian superannuation funds’ assets are invested in equities, whereas in many other countries the comparable figure is less than 40 per cent. This apparent preference for equities is, however, only a partial explanation at best. Australian superannuation funds do hold a large portfolio of fixed-income securities. However, within this portfolio, there are just not many fixed-income securities issued by the corporate sector. In contrast to only modest growth in holdings of corporate bonds, superannuation funds have purchased very large volumes of bonds issued overseas and by authorised deposit-taking institutions (ADIs) based in Australia (Graph 6). Indeed, superannuation funds’ holdings of bank bonds have risen from around $8 billion a decade ago, to around $40 billion today. This suggests that the issue is not so much a lack of appetite for bonds, but rather the relative risk-return and liquidity characteristics of the corporate bonds on offer. Graph 6 Interestingly, superannuation funds have also purchased significant volumes of bank liabilities other than bonds, including bank equity, bank short-term debt and, most notably, bank deposits (Graph 7). Indeed, bank deposits have been amongst the fastest growing asset classes for the superannuation sector over recent times. As a result of these developments, super funds currently hold $440 billion of liabilities issued by banks, representing 15 per cent of the banking sector’s total liabilities. So as things have turned out, superannuation funds, rather than financing the corporate sector directly, have helped finance the banks, which in turn have financed the corporate sector. In effect, we have seen a lengthening of the chain of financial intermediation – from savers to superannuation funds to banks to borrowers. This is not quite the financial disintermediation that some had expected a decade and a half ago. BIS central bankers’ speeches Graph 7 Superannuation funds have, nevertheless, been an important source of market-based funding through another channel – namely through the purchasing of corporate equity (Graph 8). Over the past decade, superannuation funds have increased their net investment in Australian equities by the equivalent of around 2 per cent of GDP per year, which in current dollars is equal to an annual net new investment of around $30 billion. This suggests that there is not a natural reluctance by the superannuation sector for corporate exposure, but rather that equity represents a more attractive option than debt. Graph 8 In this context, one issue that is worthy of further analysis is that of liquidity. Given that balances in superannuation funds are essentially “at call” and can be moved at short notice, these funds need to ensure that they remain quite liquid at all times. This inevitably reduces BIS central bankers’ speeches the attractiveness of relatively illiquid assets like corporate bonds. From one perspective it seems slightly curious that long-term retirement savings can be moved at short notice. Over time, there may be a benefit in exploring other arrangements that are more conducive to investments in illiquid assets. Does it matter? With these facts as background, I would like to pose the question of whether any of this really matters: does it matter whether or not we have a corporate bond market and does it matter what the size of that market is? After all, the Australian economy and financial system have performed well over the past two decades and there does not appear to have been systematic difficulties for the corporate sector in accessing finance. In answering this question it is useful to think about the implications of the corporate bond market for both the overall stability of the economy and for the efficiency of financial intermediation. In terms of stability, one of the arguments for a vibrant corporate bond market is that it can effectively act as a “spare tyre” – if the banking system gets into difficulty, the bond market can take its place in providing credit to businesses and thus allow the economy to continue operating relatively normally. The available international evidence is broadly consistent with this argument, although the transition from bank finance to bond finance in times of stress is not a seamless one given that the events that cause problems for banks can also cause markets to freeze up for a time. Nevertheless, in severe downturns, markets do seem to recover more quickly than do banks, which because they are highly leveraged, can find it difficult and time consuming to get back to normal operations.4 Interestingly, the evidence also suggests that during milder downturns, banks tend to be more stable providers of credit than are markets. This partly reflects the tendency for banks with long-term clients to keep supporting those clients if they can, whereas markets can abruptly shut for a time. The recent experience in the United States and Europe provides an illustration of the constructive role that the corporate bond market can play during times of severe stress in the banking system. Banks in these areas have been capital constrained, have faced higher costs of raising funds and have had a diminished appetite for lending. As a result, at a time when bank credit outstanding has been unchanged or declining, the outstanding value of corporate bonds on issue has been rising, particularly in the United States (Graph 9). In terms of efficiency of the financial system, the bond market can play the role of the competitive edge: ensuring that banks do not charge too high a price for financial intermediation. We saw a clear example of this in the 1990s in Australia. On that occasion, mortgage lenders were making very high returns on new mortgage loans, with the spread between the mortgage rate and the cash rate reaching around 4¾ percentage points. The RMBS market emerged partly in response to this and over time the extra competition led to mortgage spreads falling considerably. More broadly, the corporate bond market can improve the overall efficiency of the financial system through offering a broader range of maturities and loan structures than banks are able, or willing, to do. See for example Gambacorta L, Y Jing and K Tsatsaronis (2014), “Financial Structure and Growth” BIS Quarterly Review, March, pp 21–35. Available at <https://www.bis.org/publ/qtrpdf/r_qt1403e.htm>. BIS central bankers’ speeches Graph 9 So, in effect, the bond market can be seen as providing a form of insurance – insuring that in times of banking system stress the process of financial intermediation can continue and, at other times, insuring that any lack of competition in the banking sector does not lead to excessively high prices for financial intermediation. Importantly, to play this role the corporate bond market needs to be able to come to life when it is most needed – when it is needed as the spare tyre or when it is needed to provide competition. In a perfect world, the market would be deep and liquid at all times, but I don’t think this is required for the market to play this important insurance role. Instead what is needed is that we have the general infrastructure that would allow the market to respond as necessary. Here, I think Australia is relatively well placed. The legal apparatus exists to issue corporate bonds. The trading arrangements are well established. We have a reasonable number of financial institutions that are able to assist companies in issuing bonds. We have businesses that have experience in the market. And we have superannuation and other funds that are willing to purchase bonds at the right price. This financial infrastructure means that we can have some confidence that there is capacity for the corporate bond market to fulfil this important insurance role. From this perspective, the fact that over recent times the corporate bond market in Australia has been relatively subdued compared with the markets in Europe and North America can, at least partly, be explained by the different outcomes in the banking sectors. In Australia, our banks are in sound shape and have been willing to lend. In contrast, many of the North Atlantic banks have had severe difficulties and have had little appetite for new loans. Indeed, lending rates charged by euro-area banks have often exceeded the cost of bond market finance for even fairly lowly rated companies (Graph 10). In this environment, it is not surprising that bond issuance has increased. BIS central bankers’ speeches Graph 10 In contrast, in Australia, while a rise in the cost of bank funding over recent years has meant that some businesses have been able to raise funds in the bond market more cheaply than obtaining a bank loan, the number of businesses that have found themselves in this position is relatively small. By and large, the Australian banking system has been able to meet the financing needs of most of the corporate sector. Looking forward, we need to ensure that the infrastructure that supports the bond market remains in place and that it is strengthened over time. This strengthening is a gradual process and there have been some steps in this direction over recent times. These steps include: efforts to simplify prospectus requirements for retail vanilla bonds and ease the personal liability of company directors; improving market transparency through the RBA’s publication of new measures of corporate bond yields; the lengthening of the government bond curve; and the listing of certain fixed-income securities on the Australian Securities Exchange. These are all welcome developments. Conclusion In conclusion, let me try to briefly summarise. Bank-based finance remains the dominant form of finance for Australian companies. Superannuation funds have been prepared to finance banks and have effectively outsourced the credit assessment function for much of the corporate sector. Partly as a result, the development of a deep and liquid corporate bond market is still a work in progress. But an equally important observation is that we do have the infrastructure that could support a strong and very active bond market in times of stress or inadequate competition. In this way, this infrastructure provides a form of insurance. We need to make sure that we nurture this infrastructure so that we can continue to be confident that the corporate bond market will be there when it is most needed. Given this perspective, I think it is probably better to think of markets and institutions as being complements, rather than as being engaged in some type of struggle for supremacy. Thank you very much for listening. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 3 |
Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the 17th Annual Credit Suisse Asian Investment Conference, Hong Kong, 26 March 2014. | Glenn Stevens: The economic outlook Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the 17th Annual Credit Suisse Asian Investment Conference, Hong Kong, 26 March 2014. * * * I thank Alexandra Rush for assistance in compiling these remarks. When I last spoke at this conference two years ago, the United States had just avoided a feared “double-dip” recession. Europe was in the news, with acute concerns over the feedback loop between weak economies, bank asset quality and sovereign finances. China’s growth had moderated, and many feared it would decline sharply. Since then, the world economy has continued its expansion. Growth in global GDP was a bit below trend in 2013, with reasonable prospects of some pick up this year. None of the downside scenarios that have exercised minds over the past couple of years have, as yet, come to pass. That doesn’t mean they won’t, only that the world economy has been climbing the “wall of worry” for a few years now. Overall, in 2014 economic global growth is thought likely by major forecasters to be a bit higher than in 2013, and at about average pace. More of the growth is coming from the advanced countries, and proportionately not quite so much from the emerging ones. That is probably a welcome re-balancing in some respects, after the weakness of the advanced countries in recent years. The United States continues its recovery led by private demand and over the second half of last year the economy expanded at an annualised rate of just over 3 per cent. With the current agreement over the US Federal budget, one headwind from last year will abate somewhat. Of course there have been effects of the recent severe weather and it will still be a little while yet before US policymakers get a clear reading on the pace of expansion. But there is no obvious reason to expect that the expansion will be de-railed. The euro area has resumed growth, albeit in a somewhat hesitant fashion and with noticeable differences in performance by country. Some quite pronounced adjustments to cost structures are occurring in some of the so-called “peripheral” countries, as needed under the single currency area arrangement. In Japan, the initial results of the policy measures over the past 18 months have been quite positive, though of course the proposed “third arrow” reforms are yet to be fully delivered. The much anticipated “tapering” of the US Federal Reserve’s monthly asset purchases commenced in December. The initial expectation of tapering in the middle of 2013 caused more market ructions than the event itself. That said, as often occurs when the Fed changes course, investors have taken the opportunity over this period to re-assess their positions and their appetite for risk. So far, investors have not fled from risk indiscriminately. They have drawn distinctions between alternative classes of investment and the differing outlook across countries. Longterm sovereign yields for the core advanced countries remain low and, with compressed risk spreads, borrowing costs for many private-sector borrowers also remain low. A few emerging economies have lately come under pressure, with bond yields spiking and exchange rates depreciating. In most of these instances, country-specific issues can be identified as sources of legitimate concern for investors. It is notable that the number of such countries under pressure is smaller than in the middle of last year, because some have made credibility-enhancing policy adjustments in the intervening period. So far, so good, then for tapering. In my opinion, we should welcome it. BIS central bankers’ speeches There is a tendency, though, to talk about “normalisation” of monetary policy in major advanced countries as though it is happening in all of them. It isn’t: it is really only happening in the United States. Even there it is at a very early stage but the United States is actually on a path that neither the euro area nor Japan is even contemplating yet. In those jurisdictions, so far as I can tell, the discussion is about whether further easing may be in order. In fact were the Bank of Japan (BoJ) to step up its current program of quantitative and qualitative easing, it would soon be adding more cash to the global financial system, in absolute terms, than the Federal Reserve. Intriguingly, the BoJ’s actions attract rather less attention than the Fed’s. I am not in a position to opine about whether or not such further easing might occur, but the point is simply that the monetary policy trajectories of the major currency areas could diverge, and increasingly so, over the next couple of years. One interesting question is how fully this possibility is reflected in major exchange rates. Turning to the Asian region, China’s economy grew close to, and in fact a little faster than, the government’s target last year. Strong and about equal contributions to growth were made by household consumption and investment. Consumer price inflation continues to be stable. Recent indicators have shown possible signs of slower growth in the early part of 2014: growth of industrial production slowed; retail sales and passenger vehicle sales moderated; and fixed asset investment growth was a little lower in January and February, though quite stable in year-ended terms. Given that the growth target was more than met last year, and given that the Chinese New Year holiday period makes it more difficult to assess trends in the data, it may be a little too early to draw strong conclusions. Spot prices for steel and iron ore have fallen lately though, on movements to date, seem within the range seen in recent years. In fact, people may be too inclined to fret over what are still relatively small movements in monthly PMIs, and the like, in China. Sometimes they fret even more than they do over small bumps in the US economic data. The greater concern is the risks involved with the build-up of credit in so-called “shadow banking” over the past five or so years. To a considerable extent this growth in financial activity surely reflects the natural tendency to avoid the effects of price and quantity constraints imposed on the core banking sector, in an environment of strong demand for credit. In certain respects, it arguably provides genuine services to the economy. The potential problems, on the other hand, are all too familiar and well understood, at least in a qualitative sense. They include excessive maturity mismatches, where long-term loans are funded essentially by short-term borrowings; less-than-ideal transparency about asset quality; distorted incentives for provincial government entities; assumptions on the part of investors in wealth management products about major bank or government support – and so on. Recent credit events in China have increased focus on the possibility of failure of entities with non-viable business models. There has been a widening of risk spreads for lower quality credits. To some extent this could be seen as a positive development, as a clear-eyed assessment and pricing of underlying economic risks is critical for sound longer-run development in China no less than in any other nation. But of course we cannot know how much further this re-assessment of risk may have to run, nor how disruptive it could turn out to be for the Chinese financial system and the economy. It is clear that the Chinese authorities are across the issue, and in all likelihood they have the ability and resources to manage the situation. Some reforms have already been implemented, which will help to manage such risks in future, while steps taken to moderate the flows of total social financing seem, so far, to have had some success. In the meantime, a broader set of other recent reforms represent further incremental steps towards greater financial market liberalisation: the removal of restrictions on most lending rates and some liabilities, with those on deposit rates expected to follow; the recent widening BIS central bankers’ speeches of the renminbi’s trading band, as part of the central bank’s commitment to let markets play a greater role in the economy; and the introduction of the Shanghai Free Trade Zone with some associated easing of capital account restrictions. These are all welcome moves and are in China’s long-run interests. Around the Asian region generally, at this stage, our sense is that economic growth is continuing at about its trend pace. All countries will be watching closely both developments in China and the impacts on capital flows and risk-pricing as the Fed tapers and other major central banks implement their own chosen policies. Turning to the Australian economy, I continue to find a fascinating divergence between the views of foreign observers, especially in Asia, many of whom say to me “Australia is doing very well” and the tone of the commentary at home, which is typically a lot more pessimistic. My reading of the actual data is that they suggest that the economy has been doing a bit better than much of our domestic commentary over the past couple of years would have you believe, but not quite as well as many foreign investors seem to have thought. Australia certainly weathered the financial crisis well, and with a real GDP some 13 per cent larger than it was at the beginning of 2009, compares well with many other advanced countries. It is the case, though, that growth while positive, has been running at a pace a bit below its trend pace for about 18 months now. The rate of unemployment has increased by something like a percentage point over the same period. Most people are familiar with the fact that there have been very strong conditions in the natural resources sector. The biggest positive terms of trade shock in at least a century drove a mining investment boom of truly epic proportions, and that added a major impetus to demand in the economy. But the terms of trade peaked about two and a half years ago; the capital spending by the resources sector has also now peaked and is expected to decline significantly over the next couple of years. In the rest of the economy, households have spent most of the past five years behaving more conservatively, or rather more normally, than they did over a long period up to the mid 2000s when they had been in a very expansive mood. Both consumption and residential construction have been soft for a while. I have spoken at length about these trends before and explained why they were to be expected. Nonetheless, many businesses exposed to those sectors, including retailers, builders and banks, have found the going harder. In addition, because the mining boom was associated with a very high exchange rate, other trade exposed sectors have also faced more challenging conditions. Looking ahead, as the resources sector’s capital spending continues to fall, it will be desirable to see some other sources of growth strengthen. One is export volumes for resources, which are already growing strongly, as the additional capacity put in place over recent years becomes utilised. For example, iron ore shipments have risen by about 85 per cent from their levels of five years ago, to around 1.5 million tonnes per day. Exports will rise further over the coming year or two, as additional resource projects are completed and, at the margin, some other areas face slightly less of a headwind from the exchange rate. It is unlikely, though, that a pick-up in resources exports, as important as that will be, will be enough to keep overall growth on the right track. It will be helpful if some of the other areas of domestic demand that have been subdued start to grow faster. For that to occur, households would need to have made progress on their desire to sustain higher saving, and to consolidate debt where needed. Businesses outside of mining would need to have made some progress in containing costs, and raising efficiency. They would also need a bit more confidence about the future than they did before, as a pre-condition to making plans to lift their investment and add to their workforces. There are some promising signs in this regard. Recent data shows stronger household consumption over the summer. The latest surveys and our own liaison confirm this, and suggest that retailers are more optimistic than they were a year ago. That said, we expect BIS central bankers’ speeches consumption spending to grow in line with income or perhaps a little faster, but not at the pace seen in the years prior to the financial crisis. We certainly see abundant signs of confidence in the housing market. Dwelling prices have seen a broad-based rise of 10 per cent in the past year and are now about 5 per cent above the previous peak in 2010. Initially this was not associated with very much at all in the way of faster housing credit growth. That has now picked up a little, though it remains far below the rates seen in the 1990s and 2000s. The pick-up is most noticeable for investors, who need to take care with the amount of leverage they take on. It is clear that dwelling construction activity will rise strongly over the period ahead. Over the past three months, approvals to build private dwellings were at the highest rate for at least three decades. This increase is welcome, certainly at an aggregate level, since on most estimates Australia’s additions to the dwelling stock have been running at a rate below population growth over recent years. Measures of business confidence have improved over the past six months. Businesses seem, so far, to be taking a cautious approach to investment, however: they are waiting for stronger, more persistent signals of improved conditions before committing to significant increases in capital expenditure. That’s actually pretty normal in a cyclical upswing. In their hiring decisions there are some early promising signs of improvement, though it is too soon to see much in the way of concrete evidence of stronger gains in employment yet. So there is encouraging early evidence that the so-called “handover” from mining-led demand growth to broader private demand growth is beginning. Putting all this together, we think economic growth will continue, and may strengthen a little later this year and pick up further during 2015. It is important to stress that this outlook is, obviously, a balance between the large negative force of declining mining investment and, working the other way, the likely pick up in some other areas of demand helped by very low interest rates, improved confidence and so on, as well as higher resource shipments. The lower exchange rate since last April and the improved economic conditions overseas also help. Because we are trying to assess the balance between very different forces, however, there is inevitably a very substantial range of uncertainty surrounding this central outlook. That is simply unavoidable. The fact is that no one can say with certainty just how smooth a “handover” will occur. Nor can anyone pretend to be able to fine-tune it. On inflation, our view is that it will be a little higher than we thought three months ago. This takes account of the most recent data, which was higher than expected, and allows that the result conveyed at least some genuine information. Nonetheless, we think it unlikely that this signifies persistent and serious inflation pressures. Unemployment has been rising, and will probably rise a bit further yet; growth in labour costs have slowed noticeably in response. Indeed, growth of the wage price index is around the lowest in the 15-year history of the measure. Measures of unit labour cost growth are correspondingly quite low. So, absent continually rising profit margins on the part of businesses, we don’t see the conditions for persistently higher consumer price inflation, even though tradable goods prices are expected to rise due to the lower exchange rate. Measures of inflation expectations remain wellanchored and are around or below their long-run averages. Our view remains that the outlook for inflation, while a little higher than before, is still consistent with our medium-term target. Trends in asset prices are an area to watch. In particular, we need to be alert to the possibility that the past year of strong rises in dwelling prices leads people to assume that this is the norm. Were such an assumption to lead to increasing speculative activity, accompanied by a renewed increase in household leverage with all the associated risks to the housing market and the economy more generally, that would be unwelcome. This is a theme discussed in some detail in our latest Financial Stability Review, released earlier BIS central bankers’ speeches today. We are watching this closely, and we remind people that house prices can go down as well as up. In fact there have been two episodes where prices fell for a year during the past decade. The Australian Prudential Regulation Authority will also be emphasising with lenders and their boards, as it has been for some time now, the need to maintain high lending standards. There is, of course, the full panoply of other “risks” that can be identified. As always, the exchange rate is a source of significant uncertainty. Much of Australia’s outlook also depends on developments overseas. Further progress towards the full treatment of banking problems and the return to sustainable fiscal budgets in Europe will be important. With greater certainty in the United States over their fiscal policies and the path of monetary policy, the risks there may now be more on the upside. On the other hand, if some event – like a geo-political shock – led to a wider retreat from risk taking, this could have a significant dampening impact on the global economy. China’s outlook is important for Australia as, for that matter, it is for other countries. China is now the largest or second largest trade partner to most significant economies. Not only the way China manages the current financial issues, but its implementation of structural reforms, so as to maintain robust economic growth in the long run, will have an impact on all of us. Our monetary policy settings have been unchanged since last August, at what by any standard is a very accommodative level. This is playing its part in supporting sustainable growth in demand, consistent with the inflation target. We have signalled that if the economy evolves in line with the present set of forecasts, a period of stability in interest rates could be expected. Having said that, let me return to a more global perspective, to make the point that sustainable growth over the long run has to rely on more than just monetary policy. Strong long-run growth won’t be achieved in any country simply by manipulating interest rates (or, for that matter, exchange rates). Monetary policy’s main contribution over the long run is to provide a stable monetary standard. That is a necessary condition for strong growth but it is not a sufficient one. Nor will fiscal expansion serve as more than a temporary boost to growth. Indeed the limits to fiscal activism are surely all too clear in many countries now. Other conditions need to be right for growth. These include ensuring the environments for competition, innovation and investment, including in human capital, are sound. In those areas, various other government policies must come to the fore. That is the spirit in which the countries of the G20 recently committed to coming up with measures that could raise the level of world GDP by 2 per cent above what it would otherwise have been, over a horizon of five years. This isn’t to be achieved by a program of cheap money or debt-financed spending. Many of the needed measures are likely to be politically demanding for governments to introduce. But if signing up to the challenge helps to galvanise efforts for the sorts of reforms that need to be made, then it will have been a worthwhile initiative. Thank you for your attention. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 3 |
Opening remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Centre for International Finance and Regulation Conference on the Internationalisation of the Renminbi, Sydney, 26 March 2014. | Philip Lowe: Some implications of the Internationalisation of the renminbi Opening remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Centre for International Finance and Regulation Conference on the Internationalisation of the Renminbi, Sydney, 26 March 2014. * * * I would like to thank Michelle Wright for assistance in the preparation of these remarks. I would like to thank the Centre for International Finance and Regulation (CIFR) for the opportunity to open today’s conference on the internationalisation of the renminbi. This topic is an extremely important one and the Reserve Bank is a strong supporter of CIFR’s work in this area. In my own view, the internationalisation of the renminbi (RMB) – and the changes that accompany it – could ultimately prove to be as transformative for global capital markets as was the earlier opening up of China’s borders for the global trading system. Even if this turns out to be only half correct, then we need to better understand the process of internationalisation of the RMB, including the pitfalls and the opportunities. This conference is another important step in that journey of understanding. Internationalisation of the RMB and capital flows At the outset, I think it is useful to be precise about what we mean when we talk about “internationalisation”. In my view, for a country’s currency to be viewed as internationalised there are two key conditions that need to be met. The first is that the country’s currency is used for transactions between its residents and nonresidents. The progress that China is making in this area is significant, particularly on the trade side. Over the past few years, the share of China’s international trade that is denominated in RMB has risen significantly and this trend is expected to continue. On the investment side, there has been an expansion in the schemes that permit approved foreign residents to invest RMB in China. Indeed, over recent times a number of central banks (including the Reserve Bank) have invested some of their foreign currency reserves in RMB. The market for offshore RMB-denominated bonds has also grown strongly, with Chinese residents accounting for the majority of issuance. Further, plans have been announced to allow Chinese residents to invest RMB in approved offshore destinations. The second condition is that the currency is used in transactions between non-residents. In particular, a truly internationalised currency is one where: i. non-residents are willing to raise funds in that currency despite ultimately being in need of another currency; and ii. there are non-residents who are willing to hold an unhedged exposure to that currency. China has made some progress in this area, but, to date, that progress remains relatively limited. There have, for example, been some reports of non-residents issuing RMBdenominated bonds in the offshore market and swapping the proceeds into their home currencies. But in general, there is still a fair way to go here, including in the development of markets that would support the use of the RMB in this way. Ultimately, further progress in internationalising the RMB is inextricably linked to China’s transition towards capital account liberalisation and a more flexible exchange rate. Experience elsewhere around the world, including here in Australia, suggests that extensive BIS central bankers’ speeches exchange controls and a highly managed exchange rate are unlikely to be consistent with an internationalised currency. The Chinese authorities understand this and have signalled their intention to further liberalise the capital account and move to a more flexible exchange rate. We saw the latest step in this transition just last week when the daily trading range for the RMB against the US dollar was widened from ±1 per cent to ±2 per cent. While the journey is clearly a gradual one, I suspect that over the years ahead, the further liberalisation of the Chinese capital account could turn out to be one of the really significant events in global capital markets. To date, much of the capital outflow from China has been intermediated – indirectly – by the People’s Bank of China through its intervention in the foreign exchange market and its accumulation of over $US3½ trillion of foreign reserves. At some point, as controls on capital outflows are lifted, this model is likely to change. As it does, the non-official sector will become increasingly responsible for managing the foreign assets of Chinese residents. As CIFR’s report notes, this transition is likely to be associated with an increase in outflows of private capital.1 This is likely to lead to a change in the type of foreign assets that Chinese entities hold and could have significant implications for some of the asset markets in the countries that receive these inflows. The increase in private capital outflows is also likely to lead to an increase in demand for hedging products by Chinese entities, as at least some of these entities will want to hedge their currency and other risks on their new offshore investments. This growing demand can be expected to support the development of foreign exchange markets in China. The ability to hedge foreign exchange risk is – alongside the ability to denominate foreign liabilities in local currency – an important ingredient in helping ensure that the benefits associated with a more open capital account and flexible exchange rate are not outweighed by potential financial (in)stability costs. Indeed, the development of deep and liquid hedging markets is one of the reasons why Australia’s experience with capital account liberalisation and exchange rate flexibility has worked out well. When we first moved from a fixed, to a managed, to a floating exchange rate regime in the 1970s and 1980s, these markets were not particularly well developed, but they have since matured significantly. In large part, this occurred organically in response to the increase in demand for hedging products that arose once the exchange rate became more variable. This may well be the case for China too. This positive feedback loop between liberalisation and market development is also an important lesson from our own experience: if liberalisation does not occur it is hard for markets to develop, and if markets are not developed it is hard to liberalise. But a gradual process of liberalisation can promote market development and stability which makes it easier to liberalise further. One element of this positive feedback loop is that greater use of RMB for trade invoicing by Chinese firms can allow these firms to reduce currency mismatches on their balance sheets and thus alleviate potential vulnerabilities that could otherwise arise from a more flexible exchange rate regime. Another is that, as capital account liberalisation proceeds, the entry of non-residents to China’s domestic financial markets will increase the depth of these markets. And as non-residents become more willing to take on RMB exposures, the pool of potential counterparties for Chinese entities seeking to hedge their foreign currency liabilities will also increase. Centre for International Finance and Regulation (2014), “Internationalisation of the Renminbi: Pathways, Implications and Opportunities”, Research Report, March. Available at <http://www.cifr.edu.au/site/Research/Targeted_Research_RMB_Internationalisation.aspx>. BIS central bankers’ speeches Nobody knows precisely how this whole process of RMB internalisation will play out. This is partly because there is no historical precedent for an economy of China’s size and relative stage of development integrating itself into a global financial system that is as complex and interconnected as we see today. There are, as Professor Eichengreen highlights in his paper, an array of challenges, risks and uncertainties inherent to China’s transition to an open, more market-based economy. In some ways the task for China is more difficult than it has been for other countries that have made this same journey, including Australia. First, there is much more international scrutiny and the rest of the world has a very strong interest in the outcome. And second, China’s financial sector is already very large relative to GDP meaning that setbacks in the reform process could have significant effects on the broader Chinese economy. That said, if Australia’s experience is any guide, the journey can turn out to be a positive one. For us, financial reform and the integration of our capital markets into the global system delivered the basis for sounder macroeconomic policy, more diversified portfolios for Australian investors and the development of tools for hedging risks. But the journey was not without its troubles and there was much learning by doing along the way. At the beginning, the risk management skills of the Australian banks were inadequate to cope with a world in which there was much freer access to foreign capital and credit was no longer rationed. Regulators were also ill-equipped to provide effective supervision. The combination of these institutional weaknesses and intense competition among banks manifested itself most prominently in a bubble, and eventual bust, in commercial property prices in the late 1980s. Today, China is going through its own adjustment pains. But we should not forget that internationalisation of the RMB holds out the promise of the same benefits that internationalisation of the Australian dollar has delivered for us here in Australia. The effects will not only be felt in China itself, but throughout the world. Amongst other things, the opening up of China’s capital account and the process of RMB internationalisation may well elevate the RMB to international reserve currency status. While this still looks to be some way off, it would represent a profound change in the nature of the international monetary and financial system. Some of the potential impacts of all of this are explored for us in Prasanna Gai’s paper for this conference. Some implications for Australia I would now like to briefly touch on some of the implications of RMB internationalisation for us here in Australia. It is perhaps stating the obvious to say that we have a strong interest in China’s financial reform journey being a successful one. Financial reform can play a significant role in promoting economic and financial stability in our major trading partner. Furthermore, over time, a change in the structure of Chinese capital flows could have significant implications for our own capital and asset markets. And, an increased demand for hedging products and other financial instruments could open up new opportunities for our financial institutions. In the immediate future, Australia’s already strong trade links with China and the growing financial linkages between our two countries mean that there are mutually beneficial opportunities from RMB internationalisation.2 Some of these are explored in CIFR’s research report, and will be discussed by Geoff Weir later today. For example, Australia’s funds management industry can benefit from increased investment opportunities within China as inward capital flows to China increase. It can also benefit from sharing its expertise with I have previously discussed some aspects of this deepening financial relationship in Lowe P (2013), “The Journey of Financial Reform”, Address to the Australian Chamber of Commerce in Shanghai, Shanghai, 24 April. BIS central bankers’ speeches Chinese funds managers and/or providing direct funds management services to Chinese investors as private outward capital flows from China increase. Similarly, the use of RMB for trade settlement in commodity markets may also be mutually advantageous. In this context, the results of the survey that CIFR has conducted of Australian and Chinese firms’ attitudes towards the use of RMB as a trade invoicing currency are particularly relevant. The CIFR survey is an extended version of an earlier RBA survey of Australian firms that was conducted, with the help of local banks, in the lead-up to the inaugural Australia-Hong Kong Renminbi Trade and Investment Dialogue held in Sydney in April last year.3 The more recent survey – which Kathy Walsh will present later today – highlights the fact that many Chinese firms still are not aware that RMB can be used as a trade settlement currency. More positively, some of the impediments to RMB trade settlement that were evident in the RBA’s initial survey in 2013 – in particular, those related to administrative burden and payment delays – appear to have recently lessened somewhat. With the second Australia-Hong Kong Renminbi Trade and Investment Dialogue coming up in May, the survey results highlight the importance of efforts to educate firms in both Australia and China about both the RMB trade settlement process and the RMB banking and hedging products that are already available. In this regard, I welcome the Australian financial sector’s efforts to support the development of an RMB market here in Sydney, in particular, by ensuring that the current and future RMB product needs of Australian corporates are met, and that clients have ready access to information. Another encouraging sign is the recent announcements by two Chinese banks operating here in Sydney regarding RMB clearing services. Conclusion The internationalisation of the RMB – and China’s associated move towards a liberalised capital account and more flexible exchange rate regime – has the potential to create a seismic shift in the international monetary and financial landscape. And while China clearly has an interest in getting this process right, the rest of the world – including Australia – also has a strong interest in the outcome. History teaches us that financial deregulation is an inherently risky process, but that there are substantial payoffs if it is done well. Conferences like this are an important part of understanding this whole process and I wish you all the best in exploring the challenges and opportunities that lie ahead. For an overview of the results of this survey, see Ballantyne A, M Garner and M Wright (2013), “Developments in Renminbi Internationalisation”, RBA Bulletin, June, pp 65–74. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 3 |
Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce (Qld) AmCham iiNet Business Luncheon, Brisbane, 3 April 2014. | Glenn Stevens: Economic conditions and prospects Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce (Qld) AmCham iiNet Business Luncheon, Brisbane, 3 April 2014. * * * I thank Alexandra Rush for assistance in compiling these remarks. Thank you for the invitation to be in Brisbane again. Economic conditions in Queensland have been quite varied over recent years. In some ways the forces at work have been in parallel to those in the national economy. On the one hand, the expansion of the mining and gas sectors has driven strong growth in some of the regions. In the past four years, business investment in Queensland rose by 75 per cent, totalling $230 billion over that time and almost $70 billion during 2013 alone. The proportion of national investment occurring in Queensland has been unusually high. Investment in the mining sector may now have peaked, but the capacity put in place is supporting strong growth in exports. Queensland’s coal exports reached record highs over the past year and exports of LNG are expected to commence in late 2014. On the other hand, more prudent behaviour by households, after an earlier period of fairly free spending and borrowing, has kept demand in the urban areas more restrained. There was also a marked slowdown in the property sector in the southeast of the state, perhaps more so than in other states, which has been a dampener on economic activity. Part of the story here is that in an earlier environment of fairly easy access to credit, dwelling prices rose too high relative to incomes in some areas. There was also perhaps, in some instances, too much construction of the wrong sort of dwelling. Some people involved in or exposed to the property sector also had too much leverage. When credit conditions tightened and there were not enough buyers, prices fell and construction slowed down significantly. After growing at an annual average pace of 12 per cent between 2002 and the peak in late 2009, dwelling prices in Brisbane fell and remain around 5 per cent below their peak. About a third fewer dwellings were constructed in the year to September 2013, compared with the peak in 2008. Building approvals have been relatively strong in the resourceexposed regions in recent years, but elsewhere in Queensland approvals for new detached houses are at around half the 2008 level. This is something that American members of AmCham who are exposed to the US housing sector would have also felt over recent years. The US construction sector, while now established on the path of recovery, is still building only half the number of dwellings it was at the peak in 2006, and in fact is producing at two-thirds of the rate of 20 years ago. At present there are welcome signs that the Queensland housing sector is now lifting off the bottom. But this has been a long cycle. The price of Brisbane dwellings was historically about 60–65 per cent of those in Sydney. At their peak some years ago they reached about 85 per cent of Sydney levels. Now they are back to about 60–65 per cent of Sydney levels again. The cycle has taken about a decade. That the cycle can be so drawn out is a salient lesson, including for those outside Queensland. Even if a full-blown crisis does not eventuate, as was true of Australia, overdoing it on housing on the way up is usually followed by a fairly extended period of working off the problems. We have heard much of the effects of severe weather on the US economy over the recent northern winter, with these impacts complicating the task of assessing the strength of the US expansion. Weather events have also been important in Queensland in recent years, and some of them have been very costly. Not so long ago, the problems were those of floods (and indeed some areas of South-east Queensland experienced flooding over the weekend) BIS central bankers’ speeches but at present much of the State is in the grip of drought. Crops have been substantially reduced and the livestock industry will take a number of years to recover from reduced herds. Farm incomes are estimated to be falling to their lowest levels for at least three decades. I don’t think this will complicate our task of reading the pace of the national economy as much as in the US case, but these are nonetheless significant effects in regional economies. Our discussions with tourism operators, on the other hand, suggest that conditions have started to improve, partly as a result of the depreciation of the exchange rate since its peak. Over the year to September 2013, visitor spending in Queensland increased by more than 4 per cent, which is a little higher than its average historically. Tourism operators have also been tailoring their services to suit rapidly growing segments of the market, including the Chinese market, which grew by 25 per cent over the year to September 2013. Speaking of tourists, there are some rather high-profile visitors coming here later in the year. For a few days in mid November, the city of Brisbane will be the focus of the world, when the leaders of the G20 come to town. I’m not sure, actually, whether you all know what you’re in for! But on the weekend of 15–16 November, you can expect the biggest gathering of global leaders ever assembled in Australia to be in your city. Australia can host this meeting with a strong reputation for economic performance. While you might not know it from the tone of much domestic discussion, most – if not all – of the G20 membership looks at our relative growth, financial stability, banking soundness and public finances with a good deal of admiration. This has given Australia, at the margin, just a little bit of additional credibility in putting forward our agenda. Just what is that agenda? In essence, it is about growth. The Australian presidency of the G20 is focused on trying to improve global growth, with a focus on enabling investment, including infrastructure investment, and enacting structural reforms to raise the potential growth of the economies of the G20. At their meeting in Sydney in February, the G20 Finance Ministers and Central Bank Governors agreed to come to future meetings with proposed policies that would have the effect of lifting the level of the G20’s collective GDP by a little over 2 per cent by the end of five years. Let me be clear what this means. The goal is that the level of real GDP in the G20 is 2 per cent (actually a little over 2 per cent) higher by the end of five years. That could be achieved by lifting the rate of growth by 0.4 per cent per year in each year, or by a little more than that in the out years if the reforms take longer to have their effect, which they probably would. It doesn’t mean growth is 2 percentage points higher in each year (that would be a very big effect indeed). Just in case you think this doesn’t sound like such a big deal, let’s contemplate the magnitudes. Were the 2 per cent aspiration to be achieved, it would mean something of the order of US$2 trillion of additional output in the world economy, something like 15 million extra jobs spread around the G20 countries, and hundreds of billions of dollars of additional revenue for governments. It’s serious money. Let’s also be clear what this doesn’t mean. This goal is not to be achieved by clever programs of cheap money devised by central banks. Nor is it to be the result of fiscal adventurism. We are trying to shift the conversation away from the “growth versus austerity” framing of recent years, which is ultimately a rather sterile discussion. No-one has ever achieved growth simply by austerity, but equally the approach of simply ignoring the gaping hole in public finances in many countries has reached the limits of its credibility. We need a refocused conversation, around doing things that spur growth potential, which would mean, among other things, that the accommodative policies of central banks could get more traction. BIS central bankers’ speeches These things are, however, demanding. There is something of a tendency for governments, when asked to outline their growth plans, to list the things that they already want to do for political reasons, and then to claim that they will help growth. Some of those things may well help growth, but in fact many of the things that are needed to spur growth seem not to make it onto such lists. Things that boost competition in markets, that genuinely free up trade, that reform the governance and financing of infrastructure projects (and the pricing of use of infrastructure), that put retirement income streams on a sustainable footing, that re-align incentives, that allow exchange rates to be more market determined, that encourage labour market mobility and participation, that enhance human capital, and that minimise distortions from tax – many of these often don’t make in onto “to do lists” in the way that perhaps they should. So there is some hard thinking to do. Time will tell whether the countries of the G20 will rise to the challenge. But if not now, when? These issues are very real ones for Australia. For we face considerable challenges. In saying this, I am not referring to the short-run ones, to do with the “handover” from mining to nonmining investment, as difficult a challenge as that is at present. By now the proverbial pet shop residents are all talking about this: where will the growth come from after the mining investment boom ends? I suspect that plenty of the people who never thought the mining boom would do much to boost growth are among those asking the question of what will replace it as a source of growth. I’ve spoken about this a good deal in other speeches, so I will not repeat the detail today. If we manage to absorb the upward phase of the biggest terms of trade boom in more than a century without overheating, and the downward phase without a slump, that would be a major achievement. We have, by and large, managed the first part and there are some promising early signs that things may turn out not too badly in the second. But early signs are just that: early. It is far too soon to think about counting any chickens yet. Let’s also be clear that the capacity to fine-tune these outcomes is very limited. Most importantly, for today’s discussion, even if we do manage this episode as successfully as we might dare hope, major long-run challenges will remain. These are the things I want to highlight today, two of them in particular. First, fiscal sustainability. The debate here has, I would have to say, been overly- focused on budget outcomes in particular years. The real issues are medium-term ones. Put simply, there are things we want to do as a society, and have voted for, that are not fully funded by taxes over the medium term, as is starting to become clear in the lead up to the May budget. Here I refer to the very important speech given last evening by my colleague, Treasury Secretary, Martin Parkinson. 1 Our situation is not dire by the standards of other countries but neither are the issues trivial. A conversation needs to be had about this. Second, demographics. More people will be moving into retirement, and fewer people entering the workforce, over the years ahead. Our regular discussion doesn’t pay much attention to this. It’s understandable that with very public announcements of job losses – albeit many of them several years into the future – people become worried about jobs. They ask: where will future jobs come from? There are two things to say. One is they will come from areas we don’t see yet. In the middle of 1991, at the low point of the last serious recession, people were very pessimistic about future employment prospects. The rate of unemployment was in double digits. Parkinson M (2014), “Fiscal Sustainability & Living Standards – The Decade Ahead”, Speech at The Sydney Institute, Sydney, 2 April http://www.treasury.gov.au/PublicationsAndMedia/Speeches/2014/Fiscal _sustainability. BIS central bankers’ speeches But today, over 20 years later, there are nearly 4 million more jobs in the economy than there were then. The rate of unemployment, even though it has gone up recently, is just slightly more than half what it was at its peak in the 1990s. It’s worth noting that none of those additional net jobs came from manufacturing. 2 The manufacturing sector in fact shed about 100,000 jobs over that 20-year period. But other sectors increased their employment. Mining employment tripled and that alone more than offsets the reduction in manufacturing, without taking into account the growth in construction, health care and a number of other services sectors where the number of jobs has roughly doubled. As of today, even with some recent weakness, there are more jobs in the economy than ever before. The second thing to say is that, cyclical things aside, the more likely problem in the mediumterm future won’t be one of not enough jobs, but instead, not enough workers. At present the number of new entrants to the labour force after finishing education each year exceeds the number retiring. Ten years from now those numbers could be roughly equal, absent a further rise in labour participation in the older cohorts. The question will be less “where will the jobs come from?” and more “where will the workers come from?” It’s true that migration adds to the workforce as well, though migration also adds to the number of people not working and retiring. So demographic trends point in the direction of a smaller proportion of the population working, and a larger proportion needing support in their later years, even as other demands on the public finances for the provision of social goods increase. That looks like a pretty uncomfortable combination of trends. How do we reconcile them? The answer – the only answer – is growth. To some extent we will, hopefully, be able to lessen the problem through higher labour participation, for longer. But most of all we will need higher productivity of those working. That means making the system as flexible as possible and as encouraging as possible to innovation. That’s why the G20 agenda is very pertinent for Australia, notwithstanding that we have enjoyed 20 years of reasonably steady growth. I dare say it is for the United States too. We are not just talking idly about other countries lifting their growth as an intellectual exercise. We are asking how to lift our own trend growth performance. For Australia, one potential source of productivity improvement lies in the very fact that across a range of sectors the level of US productivity is much higher than our own. There may be various reasons for that, some of which we may be unable to emulate. But it’s hard to believe that there are not some, possibly substantial, “catch-up gains” available to us by adopting better practices. For the United States, it is in some ways harder because generally it is the productivity leader, so “catch-up” is not available. Observers have differing views about the ability of the United States to push up its own productivity growth in future. My own view is that the United States remains an immensely innovative society, which I think is ground for cautious optimism. In the end, increasing the potential growth of the G20 economies, and our own economy, is a challenge of the first order. The “2 per cent” goal, while subject to uncertainty and based on numerous assumptions and so on, nonetheless will hopefully force us all to confront the right set of questions. That doesn’t mean there were no new jobs in manufacturing – there undoubtedly were as the sector found things to do that it wasn’t doing before, even as things it had been doing became uneconomic and those jobs were lost. I suspect, though I cannot prove, that many of the jobs in manufacturing today did not exist 20 years ago. But in net terms the number of people in manufacturing declined by around 10 per cent since mid 1991. BIS central bankers’ speeches Before I finish, it is appropriate, particularly given the Financial System Inquiry now under way, to mention the role of finance in supporting growth. The Reserve Bank has made a submission 3 to the Inquiry. It points out that there are a few essential things that we want a financial system to do. They are to: • provide a way of exchanging value (i.e. payments services) • transfer resources between savers and investors (intermediation), with appropriate monitoring • transfer, price and manage risk • provide liquidity services. Over the past couple of centuries, the provision of such services has contributed to the accelerated pace of growth of living standards in the market economies. Recent history has been one of innovation and growth. The development of new products, efficiencies in process, and the use of information technology all held promise. They still do. Unfortunately, and this is stating the obvious, the problems that developed in the international financial system, due to serious shortcomings in key markets and institutions in some of the world’s most important economies, have meant that finance has, globally, too often been growthreducing over the past five years. Moreover, we have to question, in hindsight, the basis of some of the apparently easy growth for a few years before the crisis broke. The world learned, or rather re-learned, the lesson that finance has its own cycle – of riskseeking and then risk-aversion; of leverage and de-leveraging; of confidence, then overconfidence followed by fear or even panic. The financial system is capable of providing support for the economy and of helping it absorb shocks. But it is also capable of being a source of shocks itself. That being so, it is not surprising that, internationally, the focus since 2008 has been one of repair, re-thinking and regulatory reform. It remains a big part of the G20 agenda, with some important milestones to be passed this year. In Australia, our crisis experience was not as wrenching as for some other places. Our supervisory framework stood up to the test. Our key institutions proved to be robust and generally prudent behavior of our financial institutions stood us in good stead. Nonetheless, there were lessons to be learned, and adjustments to be made, both for supervisors and financial institutions. It is very much in our interests to absorb the lessons, and to make the sensible changes, including those that are part of international standards. The Inquiry offers the opportunity to distil those lessons, and also to contemplate the future. A financial sector that reliably and efficiently offers the services the community needs – the “handmaid of industry” – is a boon to growth and prosperity, and can play an important role in achieving the growth we want to see. Available at <http://www.rba.gov.au/publications/submissions/fin-sys-inquiry-201403/index.html>. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 4 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Economic Society of Australia, Canberra, 15 April 2014. | Guy Debelle: The Australian bond market Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Economic Society of Australia, Canberra, 15 April 2014. * * * I would like to thank Ivailo Arsov, Mathew Brooks and Karl Stacey for their assistance in preparing this speech. Thank you for inviting me to talk at the Economic Society here in Canberra. Today I am going to walk you through the current state of the Australian bond market. The bond market plays an important role in the financial structure of the Australian economy and it is timely to examine its structure and functioning with the financial system inquiry underway. I will start today by providing an overview of the composition of the Australian bond market and how this has changed in recent years. Then, I will discuss more recent developments in the market since the start of 2013, focusing particularly on two trends that emerged last year: the nascent signs of deepening of the domestic corporate bond market and the pick-up in securitised issuance. I will also talk a little about the prospect for market-based finance, of which bond issuance is an important part, playing a larger role in the future than it currently does. Shape of the Australian bond market The evolution of the Australian bond market over the past several years has been shaped to a large extent by the fallout from the global financial crisis. Prior to the crisis, the market comprised mainly bonds issued by the Australian banks and asset-backed securities. Together these accounted for just over half of the outstanding stock of Australian bonds in June 2007. Bonds issued by the public sector were a relatively small share of the market, at 16 per cent of the total outstanding (Table 1). Overall, the size of the bond market in mid 2007 was equivalent to around 84 per cent of Australia’s annual GDP. In the subsequent seven years the stock of Australian bonds on issue has increased to reach the equivalent of nearly 100 per cent of GDP. The increase has mainly been the result of debt issuance by the Commonwealth and state governments to finance their budget deficits as they sought to support economic growth through the crisis. Bank bond issuance has slowed down in the last couple of years as Australian banks have sought to shift towards more deposit funding. However, the stock of bank bonds on issue is significantly higher than it was just before the start of the global financial crisis, reflecting the strong issuance of bank bonds in 2008 and 2009 as the financial system was reintermediated because other forms of non-bank financing dried up. 1 One of the areas of the market that suffered the greatest impact from the crisis was asset-backed securities, due to the loss of investor confidence in this asset class globally. This resulted in the stock of outstanding Australian asset-backed securities nearly halving, in nominal terms, and declining three-fold relative to GDP since mid 2007. The developments in the Australian bank bond market between mid 2007 and 2009 are covered in more details in Black S, A Brassil and M Hack (2010), “Recent Trends in Australian Banks' Bond Issuance”, Reserve Bank of Australia Bulletin, March, pp 27–33. More recent developments in the banks' bond issuance are covered in Berkelmans L and A Duong (2014), “Developments in Bank’s Funding Costs and Lending Rates”, Reserve Bank of Australia Bulletin, March, pp 69–75. BIS central bankers’ speeches Table 1 Australian Bonds Outstanding* Overview of developments since 2013 Conditions faced by Australian bond issuers have continued to improve since early 2013, reflecting the markedly better conditions in global financial markets as the global economic recovery has become more entrenched and as European sovereign debt concerns have eased. Issuance has been generally strong and has been met by robust domestic and offshore demand. The only exception to this was the month of June which saw virtually no issuance of non-government bonds as issuers and investors stood on the sidelines while financial markets were assessing the prospects and implications of the start of the US Federal Reserve’s tapering to its asset purchases program. However, this episode proved short-lived, with Australian and global bond market activity resuming quickly and continuing apace when tapering actually started in December. The past year in the Australian bond market has been most notable for the signs of the improvement in investor sentiment extending along the risk spectrum towards lower rated corporate bonds and to parts of the fixed income market that have been, unfairly, at least in the case of Australia, tarred by the loss of global investor confidence. Issuance in the BIS central bankers’ speeches domestic market of lower-rated corporate bonds, which in the case of Australia means those rated BBB+ to BBB−, was the strongest on record, and, notably, at longer than usual maturities. The securitisations market, particularly for residential mortgage-backed securities (RMBS), also recorded a significant increase in activity. These trends in issuance were also reflected in the pricing of Australian bonds, with the difference in yields between these bonds and CGS narrowing across the risk spectrum since early 2013 (Graph 1). Although, the pace of narrowing has slowed relative to 2012, spreads are now at their lowest levels since the end of 2007. Borrowing costs for Australian corporates and states are at very low levels historically, while wholesale funding costs for banks, which are more a function of bond spreads rather than bond yield levels, have declined further. Graph 1 A further sign of the improved market conditions has been the continual extension in bond maturities across most market segments (Graph 2). The lengthening in maturities reflects principally two developments: improvement in overall risk sentiment; and the search for yield in a low interest rate environment pushing investors out along the yield curve in search for yield pick-up. BIS central bankers’ speeches Graph 2 Recent issuance trends I will now go through these developments in more detail. Public sector Since 2013, net issuance of CGS and semis has slowed down from the pace in recent years. Based on the latest borrowing programs and budget forecasts, the stock of public sector bonds outstanding is expected to increase to around 40 percent of GDP by 2016/17, before stabilising at that level (Graph 3). As you are aware, this is considerably lower than in most other countries. Beyond 2016/17, it is desirable to maintain a reasonable amount of CGS on issue to support a liquid government bond market and thereby provide a risk-free curve off which other debt instruments can be priced. 2 The Australian government announced in its 2011/12 Budget that in order to support a liquid and efficient bond market it will aim to maintain the stock of outstanding CGS at around 12 to 14 per cent of GDP, a level which the Reserve Bank views as appropriate for this purpose. For more details see Australian Government (2011), “Budget Strategy and Outlook 2011-12”, in Budget Paper No. 1, 2011/12 Australian Government Budget, Commonwealth of Australia, Canberra, pp 7–16 – 7–18. Available at <http://budget.gov.au/201112/content/bp1/html/index.htm>. BIS central bankers’ speeches Graph 3 Demand for Australian public sector debt has remained high due to Australia’s solid economic performance and high credit ratings of the public sector. The federal government is currently one of only 13 AAA-rated (by S&P) sovereigns globally, attracting continuing demand for CGS, particularly from official reserve managers. This demand has facilitated the lengthening in the maturity profile. In November last year, the AOFM issued a 20 year nominal fixed rate bond raising $5.9 billion. This was Australia’s largest bond issue (until the $7 billion 2026 CGS issue in March this year) and it generated significant demand with nearly $9 billion in bids and 60 per cent foreign investor participation. Bond issuance by the state borrowing authorities in recent years has featured increasing issuance of floating-rate notes (FRNs). Since early 2013 around one quarter of the issuance has been FRNs (Graph 4). The increased FRN issuance has been designed to meet the demand for such paper from banks who want to hold state government paper to meet the soon to be implemented prudential liquidity requirements. 3 Banks have a natural preference to hold FRNs to match the floating rate nature of their liabilities. The liquidity coverage ratio (LCR) requires banks to hold a proportion of their assets in high-quality liquid assets (HQLA). In Australia, only Commonwealth and state government debt are eligible securities as HQLA. Banks are required to limit their holdings to around 30 per cent of the stock on issue of these assets, to avoid impairing the liquidity in the market of holding higher amounts. BIS central bankers’ speeches Graph 4 Financial sector Gross bond issuance by Australian banks over the past year has been around its average level since 2007. Roughly three-quarters of banks’ issuance was offshore, mainly in US dollars and euros. Banks have slowed down their issuance of covered bonds now that their covered bond programs are maturing, having only been able to issue under them since late 2011 (Graph 5). 4 Graph 5 For a more in-depth discussion of the evolution of the Australian covered bonds see Aylmer C (2013), “Developments in Secured Issuance and RBA Reporting Initiatives”, Address to the Australian Securitisation Forum, Sydney, 11 November. BIS central bankers’ speeches There has been minimal net bank bond issuance in recent times, with banks basically content with their existing level of bond funding. 5 Banks have been comfortably able to fund asset growth (which has been relatively subdued) with deposits. 6 Securitisations The continual improvement in broad market sentiment has been seen strongly in the Australian asset-backed market, particularly in the market for RMBS. The volume of issuance of RMBS in 2013 was the highest since 2007 (Graph 6). The majority of issuance continues to be in Australian dollars, as has been the case in recent years, and in fact, the total Australian dollar issuance in 2013 was only exceeded by the level of Australian dollar issuance in the two and a half years immediately preceding the onset of the financial crisis. Graph 6 Despite the low level of foreign currency issuance in 2013, foreign investor demand for Australian RMBS has been quite high, reflecting the lack of supply of RMBS in foreign markets, the global search for yield, and confidence in the high quality of the underlying collateral of Australian RMBS. Publicly available data indicate that, on average, around 40 per cent of each deal in 2013 was placed with foreign investors, and foreign investor participation at issuance has increased significantly. The gradual improvement in RMBS market conditions since mid 2012, particularly the increase in private investor demand, led to the AOFM ceasing its RMBS purchases in 2012 and the government announcing the formal end of the AOFM’s RMBS investment program in April 2013. Since the start of 2013, the AOFM has sold around $1 billion of its RMBS holdings in five transactions, including in February this year the sale of a large part of its holdings of mezzanine tranches following strong investor demand for such exposures. One area where there has been stronger growth has been in the area of subordinated debt, with the banks issuing new Basel III compliant securities to refinance legacy Tier 1 and Tier 2 securities and to meet strong investor demand. The stock of outstanding government-guaranteed bonds has declined to around $23 billion, reflecting maturities and buybacks. The remaining government-guaranteed bonds mature over the next 12 months. BIS central bankers’ speeches The improvement in the RMBS market conditions has also been reflected in a number of other dimensions: • Deal sizes have increased, especially for RMBS issued by the major banks, where the average size has increased to $2.5 billion. • Issuance has picked up not only for the major banks but also for regional banks and non-banks (i.e. credit unions and mortgage originators), with a number of smaller issuers returning to the market after an absence of several years. • RMBS issuance spreads, over the last year or so, have remained at their lowest level since mid 2007; despite the significantly larger volume that has been brought to market (Graph 7). Graph 7 Deal structures have continued to evolve with further issuance of bullet tranches to manage prepayment risk. One recent deal was structured without a serial pay trigger, which has been the norm in recent years, apparently in anticipation of the changes to the APRA’s prudential standard on securitisations outlined late last year. 7 2013 saw the first Australian CMBS issue since 2011, and although volumes have remained low this has been followed by a further two transactions. Issuance of other ABS has remained strong, with 2013 recording the highest level of gross issuance on record with a sizable pick-up in Australian dollar issuance. For an outline of APRA’s proposed reforms to APS 120 see Littrell C (2013), Prudential Reform in Securitisation, Presentation to the Australian Securitisation Forum, Sydney, 11 November. Available at <http://www.apra.gov.au/Speeches/Documents/CharlesLittrell-Australian-Securitisation-Forum11November2013.pdf>. One of the major thrusts of the proposed changes is the introduction in the prudential standards of the so called “skin in the game” for ADI issued RMBS. RMBS issued since mid 2007 have typically included a serial pay trigger which after certain conditions are met, mainly satisfactory deal performance for several years after issuance, switch the principal payment order from paying tranches in order of seniority to paying all, or most tranches, proportionately to their outstanding amount. This feature was introduced in the market to address the higher cost on junior tranches in the wake of the global financial crisis and for ADI sponsored RMBS, where the sponsor has been limited to hold no more than 20 per cent of the deal to qualify for capital relief, to cap the share of the RMBS held by the ADI. BIS central bankers’ speeches Corporates Australian corporates have continued to have good access to bond markets both domestically and offshore, raising a total of $35.1 billion of new bonds since the start of 2013 (Graph 8). While the amount issued has been less than in 2012, issuance that year was underpinned by significant bond issuance by the large Australian miners. Part of the reason for that strong issuance was that the miners were able to access the market at least as cheaply as the banks, so this was very cost effective for them. As these companies have reduced capital expenditure, their need to tap the bond market for long-term funding has declined, leading to a drop-off in their bond issuance. Graph 8 The main development in the corporate bond market over the past year or so has been the significant pick-up in lower rated issuance into the domestic market and at longer maturities than have been previously achieved domestically. While domestic tenors remain well below the tenors at which corporates can raise bond funding in some offshore markets, particularly in the US, this is a very much welcomed development, reflecting the continuing maturity of the domestic market. Investors have become more comfortable with moving up the maturity spectrum and down the ratings spectrum in the domestic market in order to pick up yield and corporates are finding the pricing more attractive. The seven year maturity was the favoured point for the domestic issuance by BBB+ to BBB− rated Australian corporates, with $2.2 billion raised by 9 issuers across 10 bonds (Graph 9). How much of this will be sustained when we are no longer in a very low interest rate environment remains to be seen. BIS central bankers’ speeches Graph 9 Last year, the Reserve Bank began publishing more comprehensive measures of spreads and yields on Australian non-financial corporate bonds, covering points on the yield curve up to 10 years. 8 This additional information will bring greater transparency about bond market conditions faced by these issuers. Investor base Non-residents’ demand for Australian fixed income securities remains strong. This is particularly the case for CGS, where the share of the market held by non-residents remains close to its historical high, despite declining slightly in mid 2013 (Graph 10). A sizeable share of this demand comes from official reserve managers who are attracted to the relatively higher yield on Australian government bonds, the high and stable credit rating of the Australian government and Australia’s strong and stable economic performance. Nonresidents’ holdings of semis have continued to decrease, while the semis holdings of Australian banks have continued to increase. This reflects the demand for semis from the Australian banks, given that these securities qualify as high quality liquid assets under APRA’s rules, and offer a (small) yield pick-up over the other high quality liquid assets in Australia, CGS. The share of holdings of financial bonds by non-residents remains below the pre-crisis level as the Australian banks have reduced their funding sourced from offshore. On the other hand, the share of non-residents’ holdings of Australian corporate bonds remains at a historically high level as Australian corporates have continued to have good access to international bond markets. For details on the new measures of credit spreads see Arsov I, M Brooks and M Kosev (2013), “New Measures of Australian Corporate Credit Spreads”, Reserve Bank of Australia Bulletin, December, pp 15–26. BIS central bankers’ speeches Graph 10 Conclusions Although Australia avoided most of the more severe disruptions in financial markets during the global financial crisis, the turmoil has left its mark on the Australian bond market landscape. Conditions in financial markets have been improving steadily since mid 2012; 2013 and the first quarter of this year have resembled what normal bond market conditions may look like in a post crisis world. Looking forward, we can expect the Australian bond market to solidify this normalisation. Credit spreads are likely to remain higher than their precrisis levels, reflecting the repricing of credit and liquidity risk, while yields are likely to remain low for some time as central banks only gradually normalise their monetary policy settings. We are likely to see some further growth in the size of the public sector bond market in Australia for a little while longer, but the stock of outstanding bonds is expected to stabilise as a share of GDP by mid 2017. Issuance by the Australian banks is likely to remain subdued as they continue to favour deposit funding. Total corporate bond issuance may remain subdued in the near term as the main potential issuers – the large diversified mining companies – have a focus on increasing production from already developed projects, containing capital expenditure, and, more broadly, large Australian companies have accumulated significant cash balances since mid 2007. BIS central bankers’ speeches However, while bank-based finance remains dominant today, in the future we may well see the Australian financial system move to more market-based sources of finance, particularly bond issuance. The regulatory changes have increased the relative cost of bank intermediation, as liquidity is now more appropriately priced and the cost of maturity transformation has increased. As a result, market-based sources of finance are now more cost effective for a wider range of companies and one would expect them to respond to this with increased bond issuance. At the moment, parts of the corporate sector can access the bond market at a cheaper price than banks can. As mentioned earlier, there has been increased appetite for debt issued by lower-rated companies at attractive prices for the issuer and at longer maturities than they would normally get from a bank. How much of this is a function of the current global interest rate environment remains to be seen, but there is a reasonable prospect that some of these developments will be long-lasting. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 4 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Financial Services Institute of Australia, Adelaide, 20 May 2014. | Guy Debelle: Capital flows and the Australian dollar Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Financial Services Institute of Australia, Adelaide, 20 May 2014. * * * Thanks to Anthony Rush, Michelle Wright and Mark Wyrzykowski in the preparation of this speech. The Australian economy has been a net recipient of capital inflows from the rest of the world for almost all of its history. These net capital inflows – or the difference between foreign investment in Australia and Australian investment abroad – are the financial counterpart to Australia’s current account deficit. Put differently, investment in the Australian economy has consistently exceeded domestic saving and this gap has been funded from offshore. As I, and others, have previously argued, Australia’s current account deficit – and the associated capital inflows – is a good thing, not a bad thing.1 Cross-border capital flows allow for a more efficient allocation of global capital and can confer large benefits. In Australia’s case, foreign investment has been attracted by the favourable risk-adjusted returns on offer here and has helped to expand our domestic productive capacity. Most recently, this has been particularly evident in the role foreign investment has played in expanding the capacity of Australia’s resources sector in order to meet growing demand for our bulk commodities – particularly from China. Although net capital inflows have been a consistent feature of Australia’s balance of payments, the composition of these capital inflows – and the gross inflows and outflows underlying them – has varied significantly over time. I talked about this a little while ago,2 but it is worth revisiting today as there have been a few significant changes since then and some others are in prospect. So, today I will discuss some of these compositional changes in capital flows in more detail. I will also comment on some aspects of the relationship between these capital flows and the Australian dollar, although this is not straightforward. At a basic level, net capital inflows can be thought of as representing the appetite of foreign investors to purchase Australian dollar assets and the exchange rate is the price which adjusts so that they are willing to do this and maintain that exposure. I will conclude with a few observations on the outlook for Australian capital flows. Recent developments in Australian capital flows In the decade prior to 2007, the net inflow of capital to the Australian economy averaged around 5 per cent of GDP and peaked at almost 7 per cent of GDP just prior to the onset of the financial crisis (Graph 1). Since then, net capital inflows have declined to be under 3 per cent of GDP currently. For a more detailed discussion, see Debelle G (2011), “In Defence of Current Account Deficits”, Address at ADBI/UniSA Workshop on Growth and Integration in Asia, Adelaide, 8 July. See Debelle G (2013), “Funding the Resources Investment Boom”, Address to the Melbourne Institute Public Economic Forum, Canberra, 16 April. BIS central bankers’ speeches Graph 1 This decline in net inflows has coincided with a marked reduction in gross capital flows from their pre-crisis levels. This is not unique to Australia but is evident globally where crossborder flows are considerably lower than they were pre-crisis (Graph 2). Gross foreign investment in Australia has fallen from around 17 per cent of GDP in 2006 to around 6 per cent of GDP currently, while Australian investment abroad has fallen from 12 per cent of GDP to about 3 per cent over the same period. Graph 2 BIS central bankers’ speeches As well as the decline in gross flows, there have been three notable changes in their composition: 1. The flows to the Australian banking sector have gone from sizeable net inflows precrisis to around zero, and even small net outflows, in recent years. 2. A marked increase in foreign direct investment inflows, particularly to the resources sector. 3. A sizeable increase in foreigners’ purchases of Australian government debt. I will discuss each of these in turn. Net capital inflows to the banking sector averaged around 5½ per cent of GDP in the decade preceding the financial crisis, but have subsequently averaged close to zero (Table 1). This reflects two main factors. The first is a shift in the composition of banks’ funding. The onset of the global financial crisis led to a reassessment of the perceived risks associated with different types of funding and has seen banks shift their funding base towards domestic deposits and away from wholesale debt.3 This development does not reflect a lack of appetite for Australian bank paper, as banks’ cost of issuance has generally declined over recent years to be currently not far from pre-crisis spreads. The second factor is a reduction in loan asset growth over recent years relative to its pre-crisis levels, that is, credit growth has been slower. Table 1: Net Capital Inflows* Per cent of GDP Average over: 1998–2007 2008–2013 Private sector 5.0 1.7 Banks** 5.4 −2.0 Other financials −0.2 −2.0 Non-financials 1.6 3.8 n/a 1.6 −0.1 2.1 – Resources sector Public sector (*) Excluding households and the RBA (**) Adjusted for the US dollar swap facility in 2008 and 2009. Includes securitisers. Sources: ABS; RBA As a result, banks have scaled back the pace of offshore debt issuance, with net wholesale debt issuance averaging 1−2 per cent of GDP over 2008−2013 compared with average net debt issuance equivalent to about 5 per cent of GDP over the previous 10 years (Graph 3).4 For a more in-depth discussion of developments in banks’ funding, see Stewart C, B Robertson and A Heath (2013), “Trends in the Funding and Lending Behaviour of Australian Banks”, RBA Research Discussion Paper No 2013-15. The Australian banking sector also continues to raise short-term debt offshore, including through US money market funds as well as foreign currency deposits from customers including foreign central banks. In part, this BIS central bankers’ speeches Graph 3 The slowdown in credit growth post-crisis has been particularly evident in the low growth of lending to businesses. This is related to the second key development in the composition of Australian capital flows over recent years: an increase in net capital inflows directly to the corporate sector, rather than the funding being intermediated by the banking sector. Net inflows to private non-financial businesses have stepped up from an average of around 1½ per cent of annual GDP in the 10 years prior to the global financial crisis to around 4 per cent of annual GDP in the post-2007 period. Investment in the resources sector has been the important driver of this shift. Since 2011, around 70 per cent of foreign investment in the Australian private non-financial sector has been directed to the resources sector (Graph 4). As outlined in previous RBA work on the topic, a significant share of the very large increase in investment in resource projects has been funded through foreign direct investment in the form of retained earnings.5 To the extent that resource companies have also used external funding sources, they have generally accessed offshore debt markets directly, rather than obtain funds through the domestic banking sector.6 reflects the fact that Australian banks have higher credit ratings than most other banks, proving attractive to customers whose mandates are rating constrained. Another contributing factor is that the Australian banking sector can raise US dollar deposits from customers who do not have direct access to the US Federal Reserve and then deposit the funds at the Fed and earn the (small) spread. One might expect this activity to decline when US interest rates move away from zero. Arsov I, B Shanahan and T Williams (2013), “Funding the Australian Resources Investment Boom”, RBA Bulletin, March, pp 51–61. As I have previously discussed, a part of the reason for this preference is that a number of these resource companies have been able to access debt markets more cheaply than the banks themselves. See Debelle G (2013), “Funding the Resources Investment Boom”, Address to the Melbourne Institute Public Economic Forum, Canberra, 16 April. BIS central bankers’ speeches Graph 4 The third key development has been an increase in net capital inflows to the public sector, reflecting an increase in foreign holdings of Australian Commonwealth government debt over recent years. Gross inflows to the public sector have risen from an average of close to zero in the decade prior to the crisis to around 2½ per cent of GDP, on average, over the 2008−2013 period. The increase in foreign purchases of Australian government debt has seen the foreign ownership share of the stock of Commonwealth Government securities (CGS) increase from 50 per cent in the early 2000s to be just under 70 per cent currently, even as the stock of issuance has risen fivefold (Graph 5). At the same time, there have also been smaller net foreign purchases of Australian state government debt. But these purchases have not kept pace with net issuance by the states, resulting in the foreign ownership share of state government debt declining from around 45 per cent in 2008, to around 30 per cent currently. Graph 5 BIS central bankers’ speeches The increased foreign investment in Australian national government debt appears to have been underpinned by increased “official” holdings of Australian assets by foreign reserve managers, including central banks. I say “appears” because we don’t have any particularly concrete evidence of this. The ABS statistics do not break down the holders of Australian government debt. However, our analysis of information published by some of these sovereign asset managers suggests this is the case. This evidence is far from complete, however. With yields on Australian government debt remaining relatively high compared to a range of alternative reserve assets, and the Australian government maintaining its AAA credit rating, asset managers appear to have regarded the risk-return trade-off and diversification benefits associated with holding Australian government debt increasingly favourably. But while the foreign ownership share of Australian government debt remains historically high, the Australian dollar share of global reserve holdings is modest at less than 2 per cent on average (for those central banks for whom information on the currency denomination of their reserve assets is known). My general sense is that the bulk of sovereign asset managers now have Australian dollar assets as part of their portfolios, so there are not many new buyers left to emerge. The main chunk of diversification occurred through 2010 to 2012, although demand has remained robust since then. These changes in the composition of Australia’s capital inflows have been reflected in changes in the composition of the stock of Australia’s foreign assets and – most notably – in the composition of the stock of Australia’s foreign liabilities (Graph 6). In particular, between December 2007 and December 2013, the banking sector’s gross foreign debt liabilities have fallen by the equivalent of around 10 percentage points of GDP to around 55 per cent. Meanwhile, the public sector’s gross foreign debt liabilities have more than doubled as a share of GDP over this period (and are currently equivalent to around 20 per cent of GDP). The stock of private non-financial sector liabilities has increased by the equivalent of around 4 percentage points of GDP over this period to be currently equivalent to about 70 per cent of GDP. Graph 6 BIS central bankers’ speeches These changes in the sectoral composition of Australia’s foreign liabilities have occurred even though in overall magnitude, Australia’s net liability position has been broadly unchanged at around 55 per cent of GDP since 2007 (Graph 7). There has also been an increase in the share of net long-term debt liabilities and a corresponding decline in the share of net short-term liabilities, consistent both with the lengthening in the average tenor of banks’ debt liabilities and the shift from bank debt to public debt (public debt has a longer average tenor than bank debt).7 Graph 7 Australia’s net equity liability position has declined slightly as a share of GDP since 2007 and, in the December quarter last year, switched to a (small) net asset position for the first time since the series began. That is, Australians now own more equity investments offshore than foreigners’ own equity in Australia. The majority of this decline reflects valuation effects, rather than a marked decline or compositional change in net inflows of equity capital. Notably, Australian non-financial firms have continued to receive equity inflows, while Australian superannuation funds have continued to accumulate (large) holdings of foreign equities. The change in the composition of the stock of foreign liabilities has had a noticeable impact on the net income deficit, which is the part of the current account deficit that measures the net cost of servicing these liabilities. The net income deficit has recently declined to around its lowest share of GDP in a number of decades. In part, this reflects the lower yields on government debt than on debt issued by the banking sector as well as the historically low level of interest rates both locally and globally at the moment.8 Debelle G (2014), “The Australian Bond Market”, Speech to the Economic Society of Australia, Canberra, 15 April. These developments are discussed in Ma S (forthcoming), “Why has the Net Income Deficit Narrowed?”, RBA Bulletin, June. BIS central bankers’ speeches The outlook for capital flows Given that changes in gross inflows to the banking, resources and government sectors have had a significant influence on changes in the composition of Australian capital inflows over recent years, it is worth considering what factors might affect these flows in the future. In terms of the banking sector, it seems unlikely that the pattern of capital flows will change materially any time soon. The banks are likely to continue with little net debt issuance in the period ahead; that is, only issuing enough debt to replace that maturing. To the extent that investment in the non-resources sector is more likely to be intermediated by the banking sector than resources sector investment, the RBA’s forecast pick-up in investment in the non-resources sector might see some pick-up in business credit from its current low rate of growth. Even so, this would not require much of an increase in wholesale debt issuance given that deposit growth continues to outstrip lending growth by a few percentage points. Turning to the resources sector, the investment phase of the resource boom has peaked, and a number of resource projects are moving into the production phase. As foreign investors have played a large part in the financing of this investment, a move to the production phase should result in reduced capital inflows. At the same time, the increase in resource export volumes should increase the resources sector’s export revenue. The combination of higher revenues and lower capital expenditure outlays could be expected to lead to an increase in resources sector profits and, particularly, an increase in the share of these profits that are paid out as dividends to investors. Given that the resources sector is largely foreign-owned, this would be accompanied by an increase in dividend payments to foreign investors (an outflow on the net income component of the current account). Although the resources sector’s transition from investment to production will likely result in a reduction in net capital inflows to the sector, the effect on the Australian dollar is more nuanced. While capital inflows to the resources sector may be expected to fall (and thus reduce demand for Australian dollars), this will also be associated with declining imports to the sector, as resource investment has relied heavily on imported capital and labour. Moreover, the balance of payments records these notional foreign direct investment flows as capital inflows (and imports on the current account) even though the respective flows may have been predominantly in US dollars. The (still substantial) part of the capital inflow that represented an actual transaction in Australian dollars was that needed to pay for their workforce in Australia and the often small share of the assembly done locally. Additionally, to the extent that resource firms’ revenues are primarily denominated in US dollars and their shareholder base chooses to be paid dividends denominated in US dollars, these flows will have no net direct influence on the exchange rate. Only those flows needed to pay for the operations in Australia, to pay dividends to the Australian shareholder base and taxes to the Australian Government will result in purchases of Australian dollars. The net result of all of this is that we might expect to see reduced capital flows and reduced demand for Australian dollars as the resources sector moves into the production phase. Finally, on the outlook for investment inflows to the public sector, while the foreign ownership share of Australian government debt has declined somewhat from its peak, it remains at a historically high level. Sovereign investors tend to be relatively slow to change their portfolio allocations. Hence we might expect these holdings to be relatively sticky. Recent capital inflows to the sector suggest that demand for Australian government debt remains robust. The extent of any additional purchases will depend in part on the extent of further foreign exchange reserve accumulation by other central banks. One source of potential additional demand for government securities is from Japanese investors, who have historically held sizeable shares of Australian government debt. While there is limited evidence to date that the program of quantitative easing in Japan has encouraged investors to substantially increase their purchases of other countries’ assets, the most recent data suggest that demand for Australian debt from Japanese investors has started to pick up. BIS central bankers’ speeches Notwithstanding the possibility of these flows from Japan, the net implication of these developments is that one might expect to see reduced capital inflows in the period ahead, with the possibility of a consequent further decline in the Australian dollar. This would help in achieving balanced growth in the economy. That said, the ability of economists to forecast exchange rate movements is notoriously poor, but at least this might give you some idea of some of the dynamics at play in the period ahead. Concluding remarks To conclude, the main purpose of my speech today has been to run you through some of the notable changes in the composition of capital flows into Australia that have taken place over the past seven years or so and indicate how they might evolve in the period ahead. The major developments have been firstly, a marked reduction of net offshore debt issuance by the Australian banking sector; a trend which may be expected to continue for a while yet. Secondly, there has been a sizeable capital inflow (at least notionally) to fund the resources investment boom. As that investment boom is now transitioning into the production and export phase, these capital inflows may be expected to decline and their composition change. The third main development has been a marked increase in foreign holdings of Australian government debt. While this might not increase much further from here, nor is it likely to decline anytime soon. 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Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Federal Reserve Bank of San Francisco's Symposium on Asian Banking and Finance, San Francisco, 10 June 2014. | Glenn Stevens: Financial regulation – some observations Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Federal Reserve Bank of San Francisco’s Symposium on Asian Banking and Finance, San Francisco, 10 June 2014. * * * I thank Alexandra Rush, Carl Schwartz and Penny Smith for assistance in compiling these remarks. Introduction The Federal Reserve Bank of San Francisco has long looked to the west, to the Pacific Basin. The Center for Pacific Basin Studies was established here nearly 25 years ago, and it was a professional highlight for me to be a visiting scholar here at the time. It is a particular pleasure to return to San Francisco to take part in this Symposium on Asian Banking and Finance. Regulation and the Asian jurisdictions It is apt that the Symposium should focus on some of the regulatory challenges we are collectively seeking to address in the wake of the crisis of 2007–2008, and particularly welcome that it gives voice to partners from the Asian time zone. More than ever, finance has been global over the past couple of decades. That has brought many benefits but also certain vulnerabilities. It has also brought challenges for the regulatory community. There is a prodigious effort underway to work together to produce a regulatory framework that is genuinely international. Yet many important responses to the crisis are, and will remain, national. As such, they are at least partly driven by the circumstances and imperatives of the nations concerned. Nothing else could realistically be expected, but ensuring that all those national responses dovetail into a coherent international framework, and one that preserves what is good about globalised finance, is a difficult job. Moreover, the economic and financial importance of the Asian region is greater now than on past occasions when international regulatory standards were put together. So engaging Asia in the search for genuinely global approaches to regulation is important. To that end, the Financial Stability Board (FSB), and some of the standard-setting bodies that attend it, have adjusted their membership over the past five years in a way that recognises the importance of the Asian countries (and those of some other regions too). The FSB is currently undertaking a further review of the structure of its representation. It is nonetheless sometimes the case that the Asian members, and perhaps some other emerging market members, cannot avoid the feeling that the agenda is still driven by the major advanced economies. To the extent that those countries – the G7, say – are used to working together, and given that the financial crisis was so strongly centred in the north Atlantic countries’ financial systems, perhaps that is no big surprise. However, while that historical cooperation is a strength on which to build, it is also important that the system we build looks forward, and acknowledges that much of the future growth will be in Asia. It is also important that those of us in the Asian time zone continue to strengthen our capacity to engage effectively in the international groups of which we now have the privilege and responsibility of membership. Major themes in regulation There are many components to the international agenda for regulatory reform. The G20 is the body that has accepted, or perhaps asserted, high-level oversight over these efforts. The FSB is the body that has accepted the task of trying to ensure a coordinated effort, BIS central bankers’ speeches respecting the integrity and independence of the standard-setting bodies and addressing risks itself where required. As you know, Australia has the responsibility of the G20 presidency this year. Australia is highly supportive of the way the Chair of the FSB has structured the efforts around four key themes. They are: • increasing the resilience of financial institutions, which in the main means implementation of the Basel III standards for banks • reforming markets for trading, settling and clearing derivatives • addressing risks to the financial system from certain types of “shadow banking” • addressing the “too big to fail” problem at a global level. Highlighting these four themes doesn’t mean other things are forgotten. But it is an attempt to prioritise, to focus energies and to use the opportunity of the Leaders Summit in Brisbane, Australia, in November as a focal point for our efforts to get some important things across the line this year. Basel III The Basel III process is well on track. Most countries are well placed to implement the new international capital and liquidity standards in line with agreed timetables. Remaining policy details are being ironed out, with the leverage ratio requirement recently finalised, and further proposals on the net stable funding ratio released by the Basel Committee on Banking Supervision (BCBS). The Committee is continuing its important work to address the excessive variability in the calculation of risk-weighted assets. On the question of capital standards, it is frequently claimed that pressing major banks to hold more capital will impair economic growth. There are two points to make about this. The first is that, in situations of acute capital deficiency, it is best to address the problem as quickly as possible. Consider the contrast between the United States and Europe over the past five years. In 2009, US authorities conducted a public stress-test exercise on the balance sheets of major US banks and insisted that, where the tests revealed weaknesses, banks strengthen capital positions. They could carry out this exercise confident that a backstop capital delivery mechanism, in the form of public injections of capital, was available if private capital was not forthcoming. But it has taken much longer to get to this position in Europe. There were stress tests in earlier years but they do not seem to have had the same credibility in the eyes of markets as those undertaken by the Fed in 2009. Moreover, Europe did not have a European public capital delivery device; it was left to individual national governments to address any need for that. It is apparent that, while American banks carried out balance sheet repair early, and have for some time been in a position to help the US economy in its recovery, European banks have, in aggregate, continued to seek to deleverage by lowering their risk-weighted assets. This cannot have helped the euro area’s growth prospects.1 This is being rectified. Later this year the ECB will release the results of its Asset Quality Review, which should be a highly credible exercise. And Europe is in the process of building a single supervisory mechanism for large banks. Over time, though rather a long time, Europe is also committed to creating a single resolution capability and a Europe-wide capacity for injecting capital from a single resolution fund if needed. These are all important This is not a new lesson: it was already evident from Japan’s experience in the 1990s. BIS central bankers’ speeches steps but the respective US and European experiences do, I think, show that prompt efforts to fix serious problems of capital deficiency are ultimately pro-growth. What about in more stable times? Can banks with more capital support growth as well as those with less capital? Equity is more expensive than debt for banks, and so a financial structure with more equity does mean, other things equal, that the cost of intermediation to the community is higher. Even without appealing to propositions of a Modigliani-Miller kind, which would dispute this assumption, the question is whether this apparently higher cost is a serious impediment to growth. Bankers often claim it is. The empirical estimates published by the FSB and BCBS suggest the effect is small, particularly when compared with the costs of large financial crises.2 Stepping back from that debate for a moment, and this is my second point, we might reflect on the following question: did the highly leveraged expansion of some parts of the financial sector in the period prior to the crisis really add much, sustainably, to growth? It is far from obvious that it did. It seems more likely, to me, that it was the other way around: a period of good global growth and, in particular, unusually stable growth, led to a rise in leverage. The reasons for that growth stability were mainly not, I suspect, things that happened in the financial sector. But people concluded that macroeconomic stability meant that higher leverage was safer than before. In acting on that conclusion, they inadvertently sowed the seeds of instability, since leveraged balance sheets left borrowers and lenders more exposed when an adverse shock occurred. The feedback effects from economic growth, or lack of it, to the capital positions of financial institutions are powerful. The big question is not, in fact, what more demanding capital standards will do to economic growth. The question is: what will economic growth, or lack of it, do to banks’ capital positions? It is noteworthy in this context that the phase-in for the Basel III capital standards extends until 2019. One has to ask: how likely is it that we will go another five years without an economic downturn of some kind? Even if we do, even if we assume that growth in the United States and Europe extends to the end of this decade, by that stage these expansions would be fairly mature. Given that, one would hope that by 2019 major financial institutions would not only have reached new international minima for capital, but would have risen above them. One would hope that balance sheets by that time would be at their strongest position for the cycle. This is a reason to go faster, rather than slower, in accumulating capital to higher minima, while one can. This point is of some relevance to the discussion in my own country at present. Derivatives On the second core regulatory theme of derivatives, efforts to achieve more reporting, more platform trading and more central clearing are running behind original timetables. That is in large part due to the complexity of the issues involved in crafting mutually consistent sets of regulations at the jurisdiction level, for a market that is highly globalised in operation. The regulations of the major jurisdictions – the United States and the European Union – have considerable extraterritorial effects. It is critical that there be a high degree of consistency if we are to avoid fragmentation and unnecessary cost. The smaller jurisdictions, such as my own, feel this acutely, but it is not just a concern for the smaller jurisdictions. Even large jurisdictions would bear costs from unnecessary fragmentation. See BCBS (2010), “An Assessment of the Long-term Economic Impact of Stronger Capital and Liquidity Requirements”, August. Available at <http://www.bis.org/publ/bcbs173.pdf>; and BCBS and FSB (2010), “Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements”, Final Report, December. Available at <http://www.bis.org/publ/othp12.pdf>. BIS central bankers’ speeches What is needed is a good understanding in the various jurisdictions of each other’s regulatory arrangements, and of the areas in which they can give recognition to those arrangements. But it takes more than just verbal commitments to the concept of mutual recognition to achieve this. It requires confidence that the application and enforcement of sets of rules in other jurisdictions, which have the same intent as one’s own but which differ in precise wording or form, will in fact produce broadly equivalent outcomes. It takes time to establish that confidence, based on careful analysis, lengthy discussion and building of trust. Progress is now being achieved here, including between the two biggest jurisdictions. And the efforts of the authorities in the United States and the European Union to assess the regulatory arrangements in the various other jurisdictions, which is no small task, must be acknowledged. But we have a way to go yet. Progress could be improved if relevant international standards were the benchmark for assessments of regulatory equivalence, and if regulators clearly communicated the basis of their decisions and provided regulatory certainty by clarifying the scope for transitional relief in a timely manner. Shadow banking In respect of the third theme, there have been considerable efforts by the FSB and the standard-setting bodies to address the risks posed by shadow banking – those entities and activities beyond the perimeter of prudential regulation. As the crisis showed, this sector can be a source of systemic risk, especially in the jurisdictions where shadow banks account for a relatively large share of the financial system or are important in credit intermediation. Authorities also have to be alert to any new build-up in shadow banking risk resulting from the likely migration of some activities in response to tougher prudential regulation of banks. However, a balance needs to be struck. The jurisdictions where these problems are likely to be serious are few, and we do not want efforts to contain shadow banking activity unnecessarily to stifle genuinely productive intermediation and innovation. The FSB, International Organization of Securities Commissions (IOSCO) and the BCBS have worked on addressing risks in several areas, such as money market funds, securitisation, banks’ links with shadow banks and securities financing transactions (SFTs). Broad policy frameworks have largely been finalised in these areas, with work ongoing in relation to SFTs (such as an assessment of the impact of proposed recommendations). It has been important to retain a degree of flexibility in the policy recommendations, given that some shadow banking markets are relatively small and not likely to be a major source of systemic risk. Too big to fail On the fourth area, addressing the problem of “too big to fail” entities, a key area of work this year is to put forward a proposal for “gone-concern loss-absorbing capacity”, or “GLAC”, for global systemically important banks (G-SIBs). The idea is that, even though additional capital surcharges above the (now higher) standard Basel III minima make it less likely that a G-SIB could fail, they do not make it impossible. Such entities are sufficiently large and interconnected that an uncontrolled failure could easily cause systemic disruption. Therefore, it is argued that further loss-absorbing capacity is needed, to be called on at the point of non-viability, so as to allow vital functions to continue and non-critical operations to be wound down in a controlled way. This limits adverse spillovers to the system and the economy. Generally, this loss-absorbing capacity is to come from a “bail-in” of certain classes of private creditors, so as to avoid calling on the public purse for a “bail-out”. BIS central bankers’ speeches This is an appealing idea, though it comes with the caveat that, to my knowledge, it has not successfully been done for a major institution to date.3 There are several important issues to resolve in the process of crafting a proposal. Among them are the questions of what instruments count towards any GLAC, how much GLAC may be appropriate, and what measures can be taken to mitigate risks of contagion from GLAC holders bearing losses. On the matter of what instruments should count, a key question is whether or not equity capital above regulatory minima should qualify. The view against doing so is that equity “buffers” may turn out to be illusory in a stress situation. That is, the uncertainty over asset valuations may be such that a presumed equity buffer is not, in fact, there. The “illusory capital” problem is certainly not unknown in the annals of crisis management. The alternative view, which, it is fair to say, is more widely held, is that not to count equity above minimum requirements as GLAC would act as a disincentive for banks to hold or maintain higher than minimum equity buffers. From a risk perspective, higher equity buffers are unequivocally a good thing. Such a disincentive would therefore be unhelpful. This view is held quite strongly in Asia where banks tend to have high levels of equity capital. Under this approach, concerns about “illusory capital” could be addressed by enforceable triggers to allow early intervention when excess capital runs down to a point that breaches the GLAC requirement. Moreover, the more genuine equity a bank has, the more likely it can remain a going concern in the face of a given shock. It would still need to have a degree of recapitalisation, by a share issue, and perhaps would need to call on contingent capital instruments, triggered by some sort of capital threshold. But that would be a recapitalisation as a going concern, not a resolution as a gone concern. One would have to have a lot of confidence in a resolution regime not to prefer working with an injured but still living G-SIB, as opposed to resolving a “gone concern” one. There could still be a tail event big enough to exhaust even a higher level of equity in a G-SIB, therefore requiring resolution. And we might be uncomfortable about how quickly equity might be burned through in such an event, and we do want to be sure we can resolve a G-SIB. So some GLAC is helpful in that situation. Unless we have draconian capital standards for equity, some requirement for bail-in debt in addition to equity may well be sensible for G-SIBs. But overall it is appropriate, in my judgement, to allow equity capital in excess of regulatory minima to be counted towards GLAC requirements. Another important consideration is to mitigate the risk that imposing losses on holders of GLAC will trigger destabilising contagion among investors. Measures to protect against this risk could include: the subordination of all GLAC liabilities, to reduce creditor uncertainty about the position of GLAC liabilities in the hierarchy of claims; limitations on the term of GLAC liabilities, to guard against the potential for runs on GLAC; and measures to limit cross-holdings of GLAC by other financial institutions, to reduce the prospect of losses on GLAC holdings significantly weakening other parts of the financial system. We have seen that in times of uncertainty financial markets often shoot first and ask questions later, so the task of protecting against contagion should not be underestimated. There are examples from the recent crisis, and previous ones, where large banks have been resolved by imposing losses on their shareholders, junior bondholders and, in some cases, their senior bondholders. I am not aware, however, of any case where a bank returned from resolution as a privately owned entity, trading under its original name, having been recapitalised by private creditors alone. BIS central bankers’ speeches These and other issues on GLAC will be debated over the coming months, with the intent to put a proposal to the G20 Leaders Summit in Brisbane in November, which would then go to public consultation and a Quantitative Impact Study. Other elements in addressing “too big to fail” come under the heading of international cooperation, of a kind that goes beyond high-level statements of good intentions. By definition, the smooth resolution of a global systemically important bank would have to be an internationally cooperative one. Hence cross-border cooperation agreements, in which home and key host jurisdictions accept and agree to be bound by a framework setting out their obligations and rights, would be central. Settling these agreements is running behind the timetable originally envisaged, partly reflecting existing statutory hurdles to information sharing. Recognition of resolution actions taken in another country in respect of a G-SIB, which may involve stays of various kinds, would also be key. This will require, among other things, legislation in a number of jurisdictions. More generally, legislatures need to ensure that the relevant regulators have a mandate to cooperate effectively and share information with their counterparts elsewhere in the world and the legal tools to take part in relevant resolution actions. Limits to regulation? So there are a number of issues on which we need to make further progress by the time of the G20 Leaders Summit in November. It is to be emphasised that the work ahead is mainly not so much new regulation as the fulfilment of commitments already made, and made some time ago. What about beyond that? In particular, at what point does the agenda for better, and frankly more, regulation reach a natural conclusion? When does our focus shift from regulatory redesign, under the duress of a crisis, to operating the system in (hopefully) more normal times? And to evaluating how the strengthened regulations are working? I’m sure that is a question the regulated institutions ask. It is one the regulatory community asks as well. Central to addressing the question is the need to remember what we are trying to achieve. Put simply, we are applying the lessons learned during the crisis about the extent and nature of risk, the set of incentives that allowed it to build up, the channels of contagion for distress once the extent of risk became apparent, and the weaknesses in our collective capacity to manage a crisis when one emerged. This does not equate to a desire to eliminate all risk. In fact, risk-taking is, to a point, good. We want it to occur. That is how society advances. A problem right now, arguably, is that there is not enough genuine entrepreneurial risk occurring – judging by the low levels of private capital spending in many advanced countries. (That is a different thing from saying that there is not enough financial risk-taking occurring – various people argue that, in some respects, there is too much of that.) We do need, however, risk to be recognised, and we need to be clear about who bears it. Standard capital requirements are about ensuring shareholders accept the risks run by the firms they own. With appropriate capital structures, shareholders in financial institutions should be able to expect a reasonable, risk-adjusted, return – remembering that banking is a leveraged business and that when things go wrong the shareholders’ return can quickly become a large negative. With additional loss absorbency requirements for G-SIBs, we are asking shareholders to internalise some of the externalities very large and complex firms create for the system in the event of distress. And with the GLAC requirements, we are asking some of the other creditors to accept the risk that they may, in the face of a truly exceptional event, in effect become equity holders as part of a resolution of a G-SIB. BIS central bankers’ speeches But the risk/funding cost curve is not linear, at least not over its entire length. At some point requiring more and more loss absorbency to be provided by the private sector will come at an increasingly steep price. There must be events sufficiently far into the tails of the relevant distributions that no private balance sheet can reasonably be expected, ex ante, to bear the associated loss, no matter what the price. Should such an event occur, policymakers will still face the decision of whether to close or support the institution. The policy task is not, in my view, one of ensuring that the probability of such an event is absolutely zero, but of making it acceptably low at an acceptable price. Most particularly, we need to prevent a recurrence of a situation in which outcomes that are not, in fact, especially remote put the system in need of a public rescue. It equally follows that we are not trying to extend the regulatory “perimeter” indefinitely. There will always be some risky activity around the fringes of the system, and there is nothing particularly wrong with that. Those who seek high returns, and are prepared to accept the risk, should be allowed to do so. There is value in that occurring. The proviso is that as well as allowing such risk-takers to accept the rewards of their activities, we have to be able safely to allow them to wear the losses. We cannot have them generating significant spillovers to the parts of the financial sector that are publicly underwritten or that are key to the day-to-day functioning of the economy. Where such spillovers do exist, rules that serve to isolate the risk-taking activities, to keep them genuinely on the fringe, are in order. This is perhaps the greatest regulatory challenge for the future: assessing when an activity that is technically outside the “perimeter” might be about to present a threat to overall stability. Devoting a lot of resources to ever greater refinements to the details of existing regulatory structures will not help us do that. Having the big things inside the perimeter about right should be good enough. After that, we need to make sure we devote adequate resources to keeping a general weather eye on the broader situation, beyond just the area illuminated around our current lamp post. With the pace of technological change, it probably will not become easier to do that. The possible rise of “virtual” currencies, the potential for the distinction between regulated financial institutions and, say, telecommunications and technology companies to become blurred, to name just two developments, may pose challenges. They doubtless will not be the only ones. It probably will still pay dividends, though, to keep our antennae tuned for the nature of the promises made by the various players, the extent of leverage involved and the frequency with which we hear the cry that “this time is different”. Thank you for your attention. I wish you well in your deliberations. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 6 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Wall Street Journal's Labour Market Developments gathering, Sydney, 16 June 2014. | Christopher Kent: Cyclical and structural changes in the labour market Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Wall Street Journal’s Labour Market Developments gathering, Sydney, 16 June 2014. * * * I thank David Jacobs, Kim Edwards, Daniel De Voss, Sharon Lai and Josef Manalo for help in preparing these remarks. I appreciate the opportunity to talk to you today about some key cyclical and structural forces affecting the Australian labour market over recent years. Not surprisingly, we spend considerable time and effort at the Bank trying to understand labour market developments given their relevance to both unemployment and inflation. Developments over the past couple of years Over recent months, labour market conditions have shown some signs of improvement. Following only very modest growth last year, employment has grown by almost 0.9 per cent so far this year. The unemployment rate ticked down a few months ago and the participation rate appears to have stabilised somewhat, after a significant decline through 2013. These improvements appear consistent with some signs of better growth in economic activity, although I’ll come back to this point in a few minutes.1 Despite these improvements, there is still a fair degree of spare capacity in the labour market. This is apparent across a number of dimensions (Graph 1): • the unemployment rate is high relative to its recent history • the participation rate is around the lowest it’s been over the past eight years • there’s been a significant decline in the ratio of employment to the working-age population since 2010 • wage growth has declined, to be well below its average of the past decade. Graph 1 The lags between activity and the labour market are discussed in RBA (2014), “Box B: Lags from Activity to the Labour Market“, Statement on Monetary Policy, May, pp 39–41. BIS central bankers’ speeches My plan today is to discuss some of the key forces at play that have led the labour market to this point, and think about prospects for the future. Demand and supply: what’s driving labour market developments? Like all markets, developments in the labour market reflect the interplay of demand and supply. These determine outcomes in terms of quantities (such as employment) and prices (namely wages). There are three key developments that help to explain the dynamics over the past few years: • First, over that period there has been a weakening in the growth of labour demand, reflecting the decline in mining investment and the still weak state of overall demand across the non-mining economy. • Second, there’s been a decline in the growth of labour supply, some of which reflects a cyclical “discouraged worker” effect, but the ageing of the population is also a significant and enduring influence. • Third, wages are adjusting to the degree of spare capacity in the labour market. Moreover, slower growth of wages is playing a part in the real exchange rate adjustment that is required as the terms of trade and mining investment decline. To a large extent, these developments reflect an unwinding of some of the adjustment that was seen over the period when commodity prices were rising and the mining boom was in the midst of its investment phase. As my colleagues and I have noted elsewhere, that period saw a significant appreciation of the nominal and real exchange rates, alongside relatively strong growth in both employment and wages – particularly for mining and mining-related activities.2 These changes are now working in reverse, with the nominal exchange rate and growth of wages lower than they had been. Both are helpful parts of the necessary adjustment process. Monetary policy is also playing its role by providing support to demand. Labour demand: the transition away from mining-led growth In large part, subdued growth of labour demand over the past couple of years has reflected below-trend growth in output over much of that period. The economy has been facing various headwinds over that time, including: the decline in the terms of trade; the decline in mining investment; the high level of the exchange rate; and weak growth of public demand. The demand for labour can be thought of as being derived from the demand for the goods and services it helps to produce. So it is not surprising that employment growth weakened and the unemployment rate turned up from around the middle of 2012. That corresponded to a noticeable slowing in the growth of economic activity, which remained relatively subdued, at least up until late 2013 (Graph 2). In turn, much of that owes to the decline in mining investment. Meanwhile, growth of activity in the non-mining economy was subdued through that period, but it picked up slightly from late last year. That modest pick-up may have contributed, at least in part, to improved employment growth over the past few months. It may also be that some of that improvement reflects a “catching-up” of employment growth after only very modest growth through 2013. As discussed in Plumb M, C Kent and J Bishop (2013), “Implications for the Australian Economy of Strong Growth in Asia“, RBA Research Discussion Paper No 2013–03. BIS central bankers’ speeches Graph 2 GDP growth lifted noticeably around the turn of this year – and was running at a bit above trend over the year to the March quarter 2014. But much of that owed to a very strong contribution from the production and export of resources, which does not draw on much labour. The strength of resource production of late partly reflects an improvement in labour productivity in the mining sector, which is to be expected as new productive capacity comes on line. However, measured labour productivity growth has improved over the past few years across a broader range of industries, following a period of quite weak growth (Graph 3). If this can be sustained, it would be a very positive development, including for employees who will in time benefit through sustainable gains in their earnings. Over the past couple of years, it has meant that the growth in output that we’ve seen has been achieved with relatively moderate growth in employment. Outside of the mining sector, the general improvement in productivity growth may have been in response to a range of competitive pressures coming to bear during a period of weak growth of aggregate demand. The still high level of the exchange rate is one such competitive pressure. Graph 3 BIS central bankers’ speeches The transition from the relatively labour-intensive investment phase of the mining boom to its capital-intensive production phase is apparent in employment growth across different industries. Stepping back for a minute to the period from 2008/09 to 2011/12 (just prior to what appears to have been the peak in mining investment), resource-related activity accounted for a bit more than half of the growth in employment (Graph 4).3 Much of that was in the mining industry itself, but much was also in industries that provide inputs to resources extraction or investment. Business services, manufacturing and construction all benefitted directly from this resource-related activity. Graph 4 Now, as we are starting to see the decline in mining investment, there has been a reversal of some of these earlier trends. Most notably, business services employment has declined significantly, with firms more exposed to the mining sector particularly affected (Graph 5). Also, mining employment has plateaued since about mid-2012. Meanwhile, there has been further strong growth in employment in household services, which has accounted for a significant share of the growth in employment over recent years. There’s also been a slight upward trend in employment in construction, consistent with the prospect of a strong pick-up in both residential and non-residential building, which will require more workers in this sector in the period ahead. Rayner V and J Bishop (2013), “Industry Dimensions of the Resource Boom: An Input-Output Analysis“, RBA Research Discussion Paper No 2013–02. BIS central bankers’ speeches Graph 5 The relatively weak state of overall labour demand over the past couple of years has been evident in measures of employment intentions, job vacancies and advertisements. Some of these have shown signs of improvement of late, but they remain at relatively low levels. Households’ expectations have adjusted as well; weak growth of labour demand has translated into concerns over job security. In turn, concerns over job security and labour market conditions have led to a decline in the rate of employee resignations which, in spite of an increase in the rate of dismissals, has seen turnover in the labour market decline a little. Labour supply Labour market outcomes also depend on the supply of labour. Like labour demand, growth in labour supply has slowed substantially over the past year or so. This reflects both cyclical and structural influences. The slowing in the growth of labour supply is evident in the rate of labour force participation. A smaller proportion of the working-age population is employed or looking for work. This decline in the participation rate has been larger than the average experience during earlier episodes of rising unemployment (Graph 6). So even though the population has continued to grow at a strong rate, the growth in the labour force has been a little slower than previous experience might have suggested. Graph 6 BIS central bankers’ speeches It is not unusual for the participation rate to fall during periods of weak demand. As jobs become more difficult to find (at the prevailing wage), some individuals become discouraged from searching. These individuals may still be available to work, but they might choose to sit on the sidelines of the labour market, ready to take up an opportunity or at least begin searching for one when conditions improve. Discouraged individuals represent an element of labour market slack that is not captured by the conventional measure of unemployment because they are “marginally attached” to the labour force.4 In recent years, there has been a rise in the proportion of the working-age population that is marginally attached to the labour force, which is consistent with a discouraged worker effect (Graph 7). This has contributed to the decline in the participation rate – that is, a rise in the share of the working-age population not in the labour force. But since 2010, the rise in the marginally attached only accounts for less than one-quarter of the rise in the share of the working-age population not in the labour force. Many of those not in the labour force may still have been discouraged, but they chose to make themselves unavailable for work; for example, they may have embarked on a period of study or decided to retire earlier than might have otherwise been the case. Graph 7 The noticeable increase in the number of people that are not in the labour force and are not considered to be marginally attached suggests that there are other, potentially more structural factors at play. An important one is ageing. An increasing share of the populace is moving into older age brackets, which tend to have lower rates of participation (Graph 8). Also, older workers are more likely to work part-time, so even those participating do so with fewer hours on average than when they were in the prime of their working-age lives. The definition of marginal attachment includes individuals who are available for or searching for work, but not both (in which case they would be classified as unemployed). Note that some “discouraged” workers may not be classified as marginally attached; for example, some individuals will choose to take up further study, in which case they are no longer available for work nor are they searching for it. Conversely, some individuals will be considered marginally attached even if they are not “discouraged” from searching for a job; for example, those that are searching but not yet available to enter the labour force. BIS central bankers’ speeches Graph 8 The ageing of the population is not new. By itself, ageing is estimated to have subtracted from the participation rate by between 0.1 and 0.2 percentage points per year over the past decade and a half (Graph 9). However, the effect has picked up a little in recent years as baby boomers have begun to reach the age of 65 years. Graph 9 What has begun to deviate more noticeably from its historical path in recent years is the participation rate among older workers. In the past, rising participation of those people in older age brackets worked to more than offset the effect of an increasing share of older people in the population. That is, while the workforce was ageing, more people were working later into life than was the case in the past. In particular, older women were more likely to participate than was the case for their predecessors. But in recent years this trend increase BIS central bankers’ speeches in the participation of older age groups has slowed, and their participation rates have been flat or even falling a touch (Graph 10). Graph 10 What’s not clear though is why this upward trend has tapered off. It may be a response to the cyclical weakness in the labour market, in which case participation rates of those aged 55 years and over might trend up again, in time. Alternatively, it may be more structural. Perhaps earlier forces, including rising longevity and a general ability and preference to work later into life, may have largely run their course. However, given the long history of rising longevity, it seems likely that this will continue. One possibility though is that the forces underpinning the earlier rise in participation at older ages (including longevity) have run up against current incentives for many to retire by the age of 65 years. However, the story of lower participation rates is not entirely about ageing and the behaviour of older workers. Participation has also declined for other groups, most notably younger people – many more of whom are participating in education (Graph 11). Again, these declines may have both cyclical and structural elements. Graph 11 BIS central bankers’ speeches Wages While the growth rates of labour demand and supply have both been weaker over the past couple of years, we know that the former has been more significant than the latter. The fact that labour supply has not been constraining employment growth is evident in the rise in the unemployment rate and the substantial decline in the growth rate of wages over that period (Graph 12). Graph 12 The slowing in wage growth is clear also in the leftward shift in the distribution of wage growth across individual firms (Graph 13). The data shown here are from the NAB business survey. This is also consistent with the Bank’s liaison which suggests that wage outcomes of more than 4 per cent have become far less common than was the case a few years ago. Indeed, outcomes of 2–3 per cent are more common than 3–4 per cent. Slower wage growth has also been helped by inflation expectations remaining contained.5 Graph 13 See RBA (2013), “Box B: The Slowing in Wage Growth“, Statement on Monetary Policy, August, pp 51–52. BIS central bankers’ speeches The implications of a slowing in labour demand (relative to supply) depend significantly on the responsiveness of wages. Changes in demand will have less of an effect on employment and output if wages respond sooner and by more than otherwise. In this respect, the more flexible labour market in comparison to earlier terms of trade booms has been helpful. This flexibility allowed for a rise in relative wages to encourage labour into resource and resourcerelated activities during the run-up in mining investment, without this leading to a large rise in the growth rate of wages across the economy more broadly. The same flexibility is helping as the terms of trade and mining investment turn down.6 Indeed, the decline in wage growth of late has been particularly pronounced in mining and business services, but it is evident elsewhere (Graph 14). The move from the investment to the production phase of the mining boom is freeing up and will continue to free up labour to move back into the non-resource sectors of the economy. This has weighed on wage growth across the economy and is likely to do so for a while yet. Graph 14 The slowing in wage growth across all industries has meant that firms have experienced relatively slow growth in their labour costs. This is more striking after accounting for the growth in the productivity of labour, which as I’ve already noted has picked up somewhat compared with the pace we had become accustomed to over much of the 2000s. Over the past year and a half, the growth in nominal wages has been matched by growth in labour productivity. As a result, there has been no increase in the cost of labour required to produce a unit of output.7 In turn, slower growth in labour costs is having a beneficial effect on international competitiveness. The link between labour costs and competitiveness can be illustrated by a measure of the real exchange rate based on unit labour costs (the real trade weighted index (TWI) in Graph 15). This tells us about the labour cost of producing a unit of output in See Battellino R (2010), “Mining Booms and the Australian Economy“, RBA Bulletin, March, pp 63–69; and Plumb M, C Kent and J Bishop (2013), “Implications for the Australian Economy of Strong Growth in Asia“, RBA Research Discussion Paper No 2013–03. The average growth of nominal unit labour costs over the inflation targeting period is around 2½ per cent, which is consistent with the CPI inflation target in the absence of trend changes in firms’ profit margins or the exchange rate. BIS central bankers’ speeches Australia relative to the cost of doing so in our trading partners (both measured in equivalent currency terms). Over the decade to 2011, the real exchange rate appreciated significantly, consistent with the rise in the terms of trade and the mining investment boom. Much of that occurred via the nominal exchange rate, which appreciated by a little more than 50 per cent over that period. But part of the adjustment occurred via a pick-up in the pace of wage growth, at a time when labour productivity growth was relatively slow. Hence, nominal unit labour costs in Australia increased by around 25 per cent relative to our trading partners over this same period, contributing noticeably to the decline in competiveness (outside of the resources sector, which benefited from much higher commodity prices). Graph 15 Now that process is beginning to change course. A decline in the real exchange rate is one important way in which the economy can adjust to the decline in the terms of trade and the transition to the production phase of the mining boom. Over the past year, we’ve seen a noticeable decline in the nominal exchange rate, although it still remains high by historical standards, particularly given the further decline in commodity prices in recent months. At the same time, Australian unit labour costs have stopped rising relative to our trading partners and even declined just a little since mid-2012. This is part of the adjustment to the decline in commodity prices and will assist the non-mining economy regain some competitiveness and generate employment growth as demand for labour in the resources sector turns down. Adjustment via slower wage growth and stronger productivity growth may not contribute as much nor as quickly to a real depreciation as might be expected from a decline in the nominal exchange rate. However, it is still preferable to the alternative of little or no adjustment in the growth of unit labour costs, which would come at the expense of more unemployment and the associated economic and social costs. Conclusions To conclude, growth in both labour demand and labour supply has been slow over recent years. Demand for labour has been affected by several headwinds. The downturn in mining investment has weighed on domestic demand, while the commensurate pick-up in exports has been less labour intensive. On the labour supply side, much of the slowdown is likely to have had a cyclical element, although structural factors such as ageing are also playing a role. BIS central bankers’ speeches The slower growth of wages over the past couple of years has been a helpful part of the process of adjusting to the downturn in commodity prices and mining investment. The decline in wage growth has contributed, at the margins, to a turnaround in the real exchange rate and helped cushion the effect of slower growth of domestic demand on employment growth. It has also helped to contain domestic cost pressures thereby offsetting the effect of the lower exchange rate on consumer prices. The demand for labour has improved over recent months, although some of that may reflect a “catch-up” after a period of weak employment growth last year. Some forward-looking indicators are higher than they have been, though they are still at levels consistent with only moderate employment growth in the next few months. The Bank’s latest forecasts are for employment growth to pick up gradually over the next two years. The unemployment rate is expected to remain elevated over that period, declining from later in 2015 when we anticipate GDP growth to be picking up to an above-trend pace. Looking well beyond that horizon, demographic changes loom large and will play an increasing role in the discussion of labour market developments. As we’ve suggested on a number of occasions, in time it is likely that the availability of workers, not jobs, will be the main concern.8[8] And in that world, one imagines that real wages might grow a little more rapidly than otherwise, in order to encourage participation. See Stevens G (2014), “Economic Conditions and Prospects”, Speech to the American Chamber of Commerce (Qld) AmCham iiNet Business Luncheon, Brisbane, 3 April; and Kulish M, C Kent and K Smith (2010), “Aging, Retirement, and Savings: A General Equilibrium Analysis”, The B.E. Journal of Macroeconomics, 10(1), pp 1–32. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 6 |
Opening statement by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, and Mr David Orsmond, Deputy Head of Economic Analysis of the Reserve Bank of Australia, to House of Representatives Standing Committee on Economics Inquiry into Foreign Investment in Residential Real Estate, Sydney, 27 June 2014. | Christopher Kent: Foreign investment in residential real estate Opening statement by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, and Mr David Orsmond, Deputy Head of Economic Analysis of the Reserve Bank of Australia, to House of Representatives Standing Committee on Economics Inquiry into Foreign Investment in Residential Real Estate, Sydney, 27 June 2014. * * * Thank you, Chair, for the opportunity to discuss this topic with you today. As summarised in our Submission,1 foreign residential investment has been a feature of Australia’s housing sector for many decades. Foreign demand for housing has supported the local construction industry, while foreign-based developers provide access to alternative sources of financing and add a degree of competition to the sector. Some recent housing purchases have also been associated with the increase in the number of families, particularly from Asia, that want to educate their children in Australia. More broadly, foreign residential demand in Australia is linked to the rise in income and wealth globally, but particularly in Asia, which is adding to business opportunities as our economy becomes more integrated with others in the region. This is welcome and to be expected. An underlying theme in much of the commentary has been whether foreign residential investment has increased the demand for Australian housing by more than it has increased supply, and hence whether it has led to an increase in housing prices, especially for first home buyers. The data clearly show an increase in the level of approvals for foreign residential purchases over time, but it is difficult to know how much this has boosted net demand for Australian housing. While varying a bit from year to year, the data published by the Foreign Investment Review Board (FIRB) suggest that foreign purchase approvals have been fairly low as a share of national housing turnover. Specifically, the FIRB data suggest that the value of foreign residential approvals has generally been around 5–10 per cent of the value of national housing turnover. Using several assumptions, we estimate that the number of foreign approvals has been around half of that range. In its Submission to this Committee, FIRB included data covering the first three quarters of this financial year, which show a rise in approvals, especially for new dwellings. Nonetheless, it is important to remember that the share of actual residential purchases by foreign and temporary residents is likely to be much lower than the FIRB data suggest because not all approvals lead to a purchase. This point is outlined in our Submission and in a recent article published in the Bank’s Bulletin.2 It is worth emphasising that the purchase of a property by a foreign citizen or temporary resident may not contribute one for one to net housing demand in Australia. For instance, there would be little effect on net demand if the property purchased is used to house foreign students who would otherwise have needed to rent during their stay here. Similarly, net demand for housing would be little changed if an investment property is subsequently rented out. There is no comprehensive information on the magnitude of these types of transactions. So, while it seems likely that foreign residential purchases have added somewhat to net housing demand in Australia, there is no way of knowing the exact extent to which this has been the case. Whether an increase in net housing demand – be it from foreign or domestic sources – leads to higher housing prices depends on the responsiveness of supply. This subject has been See RBA (2014), “Submission to the Inquiry into Foreign Investment in Residential Real Estate”, 9 May. See Gauder M, C Houssard and D Orsmond (2014), “Foreign Investment in Residential Real Estate”, RBA Bulletin, June, pp 11–18. BIS central bankers’ speeches especially topical of late, with housing prices nationally rising by close to 10 per cent over the past year. The rise in prices has primarily reflected increased housing demand from Australian residents and citizens, partly owing to low interest rates. The supply of housing is responsive to a rise in housing demand but, given the time needed to plan and build new housing, this typically occurs with some lag. However, several factors can accentuate this lag, including: • a shortage of well-located land and geographical constraints in our capital cities • the complexity of the planning and approval process, which adds to the time and costs of new housing developments • concerns of existing residents in regard to new development projects in their vicinity. These are not easy issues to address, although it is widely agreed that an appropriate balance needs to be struck if housing is to be provided at a reasonable cost. Through the Bank’s business liaison, we hear from housing market participants that impediments to increasing the supply of housing in some greenfield areas have eased in recent years. Also, there has been interest in converting some of the older office buildings in central business districts into residential use, which may ease the shortage of land in highly sought after areas. However, our contacts also report that more could be done to increase the responsiveness of housing supply to demand. Notwithstanding general concerns about the responsiveness of supply, the information available suggests that foreign residential purchases have probably not had a large direct effect on the price of housing that is typically purchased by first home buyers. While incomplete, the FIRB data and the information received through our liaison with developers suggest that most foreign residential purchases are for new, higher-density, inner-city properties as well as properties close to universities. Furthermore, the properties they purchase tend to be valued well above the average national sales price. In contrast, most purchases by first home buyers have been for established homes that are priced well below the national average. Moreover, when they do purchase new housing, first home buyers appear to generally purchase detached homes close to the fringe of the main cities rather than new apartments located close to the city centres. Of course, there are some foreign buyers that purchase cheaper homes outside the inner-city areas, just as there are some first home buyers that purchase inner-city properties priced above the national average. But in the main, foreign buyers appear to be purchasing properties that are typically quite different in their characteristics from those purchased by most first home buyers. Finally, I would like to comment on the issue of the availability of data. FIRB’s main role is to ensure foreign purchases are consistent with the rules, rather than to provide data on the actual level of foreign investment. Even so, a case could be made for more timely provision of the approvals data that are already collected by FIRB, perhaps publishing them on a quarterly rather than annual basis. Also, more granular data could be provided, such as the number of approvals within broad price brackets rather than just the total value and number of approvals. Beyond that, the benefits of any new reporting requirements in this area should be weighed carefully against the costs of its collection and administration. With those introductory comments, my colleague, Dr David Orsmond, and I are happy to take any questions you may have. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 6 |
Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Econometric Society Australasian Meeting and the Australian Conference of Economists, Hobart, 3 July 2014. | Glenn Stevens: Economic update Speech by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Econometric Society Australasian Meeting and the Australian Conference of Economists, Hobart, 3 July 2014. * * * I thank Alexandra Rush for assistance in compiling these remarks and Selwyn Cornish for comments on the historical material. Thank you for the invitation to visit Hobart – in winter! – and to take part in this conference. Economics in Tasmania This year marks a century of economics at the University of Tasmania, dating from the time Herbert Heaton took up duties as a lecturer in History and Economics in 1914. Heaton’s pacifist and somewhat left-leaning views apparently caused some controversy, both in Tasmania and subsequently at the University of Adelaide. He left Australia in 1925 for Canada, and later had a successful academic career at the University of Minnesota.1 Over the ensuing period, some of the greatest names in Australian economics studied here, taught here or otherwise carried out some part of their professional duties here. It’s quite a line-up. There was LF Giblin, born in Tasmania, sportsman, student at Cambridge, some-time acquaintance of the Bloomsbury Set, Yukon adventurer, enlisted soldier in middle age and wounded three times in the First World War, Tasmanian Government Statistician, adviser to government on economic policy in the 1930s depression and board member of the Commonwealth Bank. Then there were those called “Giblin’s Platoon” in the very nice book of that name by William Coleman, Selwyn Cornish and Alf Hagger:2 • Sir Douglas Copland, lecturer at University of Tasmania, the first dean of the University of Tasmania faculty of commerce, Professor at the University of Melbourne, adviser, contributor to Depression era policies, inaugural Alfred Marshall lecturer at Cambridge, diplomat and founding Vice Chancellor of the Australian National University. He was succeeded at the University of Tasmania by James Bristock Brigden. • Brigden, like Giblin a soldier, also wounded, post-war lecturer in Economics here at the University of Tasmania, Director of the Queensland Bureau of Economics and Statistics, Secretary of a number of government departments during WWII, influential in the development of tariff and wage policies, and diplomat in Washington. • Sir Roland Wilson, born in Tasmania, completed a bachelor of commerce at the University of Tasmania (taught by Brigden and Copland), where he later lectured in economics. He was later Commonwealth Statistician, turning down a chair at the university here to remain in Canberra, took up diplomatic roles in Washington upon See <http://adb.anu.edu.au/biography/heaton-herbert-6626>. Coleman W, S Cornish, AJ Haggar, (2006), Giblin’s Platoon: The trials and triumph of the economist in Australian public life, ANU Press, Canberra. Available at <http://press.anu.edu.au?p=55501>. BIS central bankers’ speeches Brigden’s retirement, became Chairman of the UN Employment Commission and was the longest-serving Secretary to the Australian Treasury.3 Coleman et al. chronicle the way the relationships between these four bore fruit. It was a remarkable period of activity for the fledgling profession in this country, and people who had been or were associated in some way with the University of Tasmania were in the thick of it. It might be said that, in many respects, much of the genesis of modern policy economics in Australia occurred here in Hobart. Every generation has its own challenges. In the careers of today’s generation of economists we have had, as described by various authors, “the Great Inflation”, “the Great Moderation”, “the Great Recession”. The ensuing slow recovery in the advanced countries could be described as “the Great Disappointment”, though one commentator has used stronger language – describing it, rather biblically, as “the Great Tribulation”.4 Maybe there is undue devaluation of the adjective “great” in such characterisations. Or maybe not. The generation of Giblin et al. faced enormous challenges, especially given the much more limited stock of accumulated knowledge at that time and the scarcity of trained economists.5 But plenty of writers, including some who have been intimately involved in policymaking, have seen the recent episode as potentially as catastrophic as the 1930s, averted only due to interventions framed with the lessons of the 1930s in mind. But a fuller evaluation of those issues may need to wait for another occasion. Today I propose something less ambitious. In early May, the Bank published its latest Statement on Monetary Policy. Since then we have had the Federal and some state budgets, and some further data as well as a couple of interest rate decisions. Hence, it seems appropriate to provide a brief update and some comments on a few issues connected with monetary policy. Economic update It appears that the economy’s pace of growth increased somewhat in the second half of last year, and that this persisted in the first few months of 2014. Real GDP expanded at an annualised pace of about 3 per cent in the second half of 2013, up from just under 2½ per cent in the first half. Business survey readings are broadly consistent with this picture. The March quarter of 2014 saw a further pick up, to something that was above trend, measured either in the quarter or over the year. A key question is the extent to which these recent national accounts data in particular illustrate the likely ongoing pace of growth. The results owed a lot to a very substantial rise in resource exports. This in turn reflected new capacity coming on stream and also unusually benign weather. While further rises in resource export volumes are expected, they are unlikely to be at the same pace. Hence, the most recent set of GDP figures, while certainly encouraging, probably overstate somewhat the true ongoing pace of growth in the economy. The Bank’s forecasts from early May, which we have not materially changed, embody ongoing growth but, in the near term, probably a little below trend. We will provide an update of forecasts next month. We could add Sir Edward Ronald Walker, professor of Economics at the University of Tasmania, adviser to the State government, head of the delegation to the 1945 Paris Conference, diplomat and chair of the UN Committee on Full Employment in the late 1940s. We could also mention Professor Gerald Firth, who travelled from the UK to take up the Ritchie Research Fellowship funded by Giblin at the University of Melbourne, was a senior economist in the Department of Post-war Reconstruction and was Professor of Economics at UTAS for around 30 years. See Charles Bean, <http://www.bankofengland.co.uk/publications/Pages/speeches/2014/729.aspx>. It’s remarkable that Sir Roland Wilson was, according to Coleman et al., the first university graduate appointed to an administrative position in the Commonwealth Public service, in 1932. BIS central bankers’ speeches What are some of the key features of this outlook? The world economy continues to show moderate growth, probably a little below average but not by all that much. The advanced countries are seeing somewhat better outcomes than last year overall, while some emerging market economies slowed somewhat during the first half of 2014, including China. Looking at domestic economic policies, the stance of monetary policy is very accommodative, certainly when measured by the metric of interest rates. The level of rates, including for borrowers, is at a 50-year low. The cash rate measured in “real” terms is approximately zero. In either nominal or real terms the cash rate is well below “normal” levels, and comfortably below even the mooted lower “new normal” levels. Moreover, we still have “ammunition” on interest rates – we have not got close to the zero lower bound that has afflicted some other countries. The low interest rates have been having many of the effects they normally do. Savers have altered their behaviour to look for returns in slightly more risky assets; asset prices have risen; demand for credit has strengthened; and interest sensitive areas of spending, like some areas of consumption and especially dwelling construction, have firmed. The exchange rate also declined, though not by as much as might have been expected. The full effects of the very accommodative stance of policy have not been seen at this stage. It will be supporting demand for some time yet. The Federal Budget seems unlikely materially to change the near-term outlook. Over the next couple of years the estimated impact of the budget is not very different from what we had previously been assuming, and the extent of fiscal contraction, as conventionally measured, is actually not particularly large when compared with past episodes of fiscal tightening. Beyond that period, the measures in the budget will result in a more significant consolidation than earlier assumed. It was over that more medium-term horizon that the Commonwealth’s finances, left unattended, looked like they were going to start going more seriously off course. So the timing of the intended consolidation seems broadly sensible. That having been said, the fact that the real issues with public finances are medium-term ones is not a reason to put off taking decisions to address them. On the contrary, as experience in so many other countries demonstrates, by the time these sorts of problems have gone from being out on the horizon to on our doorstep, they have usually become a lot more difficult to tackle. Early, measured actions that have effects that build up over time are a much better approach than the much tougher response that might be required if decisions were delayed. There has been discussion about confidence effects of the budget. Some surveys do suggest some decline in household confidence of late. It is important, though, to ask how persistent such effects might be. Last year’s budget, which contained some tough messages, also seemed to be associated with a decline in such measures of confidence. They recovered after a few months. We can only wait to see whether that pattern will be repeated this year. Measures of business confidence don’t show any obvious response to the budget. While there has been much focus on budget measures, the biggest sources of uncertainty about the pace of private demand growth remain the speed of the impending large decline in capital spending by the resources sector, and the timing of the recovery in non-mining capital spending and non-mining activity more generally. The biggest and most persistent terms of trade gain in at least a century ushered in a capital spending response by mining and energy companies that saw the private business investment share of GDP reach a 50-year high, even though investment outside the mining sector approached recession-level lows. Now, the terms of trade are falling, and the investment part of the boom has peaked. Mining investment, as a share of GDP, has BIS central bankers’ speeches probably already declined by about 1 percentage point, and is expected to fall by another 3 or 4 percentage points over the next few years. Unlike in all previous such booms, we did not experience serious overheating in the upswing. What is being attempted now is to negotiate the downswing phase without the slump that characterised the aftermath of all the other booms.6 The fact that the upswing was managed without the excesses of the previous episodes is no guarantee of success in the next phase, but it has to be a good starting point. We have seen some encouraging early signs of the “rebalancing” taking place. Consumer demand has been rising moderately, even if recently perhaps a little more slowly than it did over the summer. Residential construction is moving up strongly, and intentions to invest outside the resources sector have started to improve, from very subdued levels. The labour market has also shown some early indications of mild improvement. But these signs remain early ones. There is quite some way to go yet before the episode is completed. Meanwhile, the environment seems likely to be one in which a number of sectors are making serious efforts to contain costs and lift productivity (Graph 1). That amounts to an outlook for wages and prices that does not appear to threaten the inflation target, even were we to see a somewhat lower exchange rate. Perhaps more fundamentally, a better trend for productivity, if we can sustain it – and especially if it can be further improved – would be a reliable basis for optimism about the longer-run prospects for the economy and our living standards. Graph 1 Communication about monetary policy It is in that context that the Board has left the cash rate unchanged at 2.5 per cent for almost a year now. For an insightful treatment of the previous booms, see Ric Battellino’s speech “Mining Booms and the Australian Economy” (2010). BIS central bankers’ speeches For rates to have been stable for this long isn’t unprecedented. But since markets and media commentators find the idea of masterly inaction neither appealing nor interesting, this has put more focus on communication. The Bank’s language has evolved, given the passage of time and the flow of new information. Up to the time of last August’s meeting, the post-Board statement for some months included language about the inflation outlook, as then assessed, providing “scope” to ease further should that be appropriate to support demand. At the May and August 2013 meetings the Board used some of that scope. Subsequent post-meeting statements did not include that phrasing. The minutes of those meetings simply recorded the Board’s view that “the Bank should neither close off the possibility of reducing rates further, nor signal an imminent intention to reduce rates further”. That phrasing was retained until the December minutes. The data that emerged over the summer saw somewhat firmer growth, a lower exchange rate and higher inflation than had been embodied in the outlook as at the end of last year. This led the staff forecasts for both growth and prices to be revised higher for the February meeting and the subsequent Statement on Monetary Policy. The December quarter CPI in particular was something of a surprise. We interpreted those data as containing a degree of noise but could not entirely discount the possibility that they may also contain some signal. Hence, the inflation forecast was revised up somewhat. With both growth and inflation forecasts moving higher, it would have been odd to continue with the earlier language. After all, policy had been eased a great deal, it seemed to be having many of the expected sorts of effects, inflation wasn’t threatening to be too low and, if anything, was going to be higher than earlier expected, and there was mildly better news on output. Accordingly, the Bank’s communication continued to evolve in light of new information. Although this shift in language was quite gradual, the problem we can sometimes have in such periods is that people may react by thinking that, if the Bank is not thinking about easing, then it must be thinking about tightening. But we were not contemplating tightening. In fact, the conclusion we had reached was that we might be on the brink of sitting still for some time. That is why we adopted language about “stability” in interest rates, the intended effect of which was to be clear to people that we did not think that higher interest rates were imminent. That has not stopped people from opining about the timing of possible future increases – or, indeed, decreases. That’s what makes a market – people have differing views, for various reasons. Overall, I judge that language to have served its intended purpose. Present market pricing suggests that market participants expect interest rates to remain low for some time yet. If anything, pricing in recent days has suggested that, if a move were to occur over the next several months, markets expect it would be down, not up. Any increase in rates is thought by market participants, on average, to be unlikely for quite some time. The evolution of language should be expected to continue, as more time passes and further information comes to hand. Long before any thought were to be given to an increase in rates, it would probably be sensible for the Board to cease references to a future “period of stability” and revert to the more normal formulation that the stable policy settings “remained appropriate” or something like that. Such an evolution would amount to no more than a recognition that a “period of stability” had in fact already been occurring and wasn’t entirely in the future, but wouldn’t imply any particular change in the Bank’s views about the future course of policy. It should go without saying that those seeking to understand our thinking should, in any event, look not just at the wording in the post-Board statement, nor just that in the minutes, but also at the whole analysis of the economy and the outlook in the regular Statement on Monetary Policy. BIS central bankers’ speeches The exchange rate Another issue in communication has been how to describe the exchange rate. For a period we described it as “uncomfortably high”. It subsequently declined, though we suspect that was due more to a change in mood in global capital markets than to our words per se. We altered our language to reflect that decline, and then adjusted it again as the currency re-traced some of that rise. There seems to have been a very strong focus on whether the adjective “uncomfortable” would be put into use once more in the post-Board statements. It hasn’t been, though I don’t regard that to be as significant as many people seem to think it is. We have tried to avoid frequent and large language shifts about the exchange rate. It can vary enough from month to month that we risk chasing our tails if we seek to engage too actively in “jawboning” each month. But lest there be any uncertainty about this, let me be clear, again, that the exchange rate remains high by historical standards. There is little doubt that significant parts of the tradeexposed sectors still find it quite “uncomfortable”: it continues to exert acute pressure for cost containment, productivity improvement and business model change. When judged against current and likely future trends in the terms of trade, and Australia’s still high costs of production relative to those elsewhere in the world, most measurements would say it is overvalued, and not by just a few cents. Of course, we live in unusual times, with interest rates at the “zero lower bound” in several major jurisdictions. Nonetheless, we think that investors are under-estimating the likelihood of a significant fall in the Australian dollar at some point. Housing prices Finally on communication and monetary policy generally, there is the question of housing prices. Few issues seem as capable of sharply dividing opinions as this one. Some use the “B” word, sometimes followed by calls for interest rates to be higher. Others regard it as unthinkable that interest rates would ever respond to housing prices. Still others call for regulatory actions to constrain housing lending, which, by the way, has overall remained quite moderate so far. The Bank’s views on this have been quite consistent. We have made four points. First, with dwelling prices having fallen between 2010 and 2012, some recovery was not in itself particularly cause for concern, certainly not initially. Moreover, if we think there is a need for higher construction, which we do, an environment of declining prices is probably not conducive to that outcome. Some pick-up in housing prices as a result of lower interest rates was to be expected; it shows that monetary policy is working and is part of the normal transmission process. Of course, this argument becomes less persuasive if valuations reach new highs and keep rising. So, second, were there to be a further big run-up in prices, with past increases leading to overconfident expectations of continuing gains, it would be a different matter. If this were accompanied by a return to significant increases in household leverage, from already high levels, that would be a matter for concern. It would be adding risk to the system. But, third, to date the amount of new borrowing does not appear, overall, to be imprudent. The rise in the value of loan approvals over the past year of around 20 per cent is certainly significant. It’s important to note, however, that scaled by the amount of credit outstanding, the rate of this flow over recent months, while clearly well off its 2011 low point, is actually not that high compared with longer-run history (Graph 2). It’s only a little above 2008 lows, in fact. The growth of credit outstanding for housing is about 6–7 per cent per annum, or slightly above trend nominal income growth. It’s hard to mount the soap box to complain about that pace. BIS central bankers’ speeches Graph 2 Nonetheless, fourth, investors should take care in the Sydney market, which is the main area where a large increase in borrowing has been occurring. The total value of credit approvals for investor loans in New South Wales as a whole is about 130 per cent higher than in 2008, and it is in the investor segment where there has been evidence of some increase in lending with loan-to-value ratios above 80 per cent in the past couple of quarters. Here we continue to have two messages. The first is that in forming expectations about future price gains and deciding their financing structure, people should not assume that prices always rise. They don’t; sometimes they fall. The second is that banks and other lenders need to maintain strong lending standards. APRA has helpfully been reinforcing this point directly with bank boards, as well as stressing the importance of having adequate, higher, interest rate buffers in place, given the current very low level of rates in the market.7 The maintenance of strong standards will be all the more important given the significant improvement in access to funding via the securitisation market over the past year and the associated increase in competition to lend. Some segments of the housing market do appear to have been calming down lately. Prices have flattened out in several cities and even in Sydney the pace of increase has lessened. It remains to be seen whether this slower pace of growth in dwelling prices is temporary or more persistent. It would in my opinion be good, for a range of reasons, if it did persist for a while. If the next couple of years saw an unremarkable performance on prices, and construction staying at the higher levels that will clearly be reached over the coming year, it would be an outcome that would contribute to a balanced growth path for the economy and to housing more people at manageable cost. Overall, the Bank has not seen developments in the housing market as warranting higher interest rates than the ones we have had, in the current circumstances. This isn’t because we think that financial stability considerations should be ignored in the policy decision. On the See <http://www.apra.gov.au/adi/Documents/Draft-PPG-APG223.pdf>. BIS central bankers’ speeches contrary, they should be, and have been, given due weight, along with all the other factors we have to take into account, in deciding the interest rate path we have chosen. We judge that path to have best balanced, to date, all the various considerations. Conclusion I wonder whether Giblin and his “platoon” could have imagined a meeting like this: hundreds of economists and econometricians converging, from around the country and around the world, on Hobart for just a few days, travelling not at stately pace in ships and trains, as they would have, but through the stratosphere at just under the speed of sound. Probably not. But at least some of the issues about which we talk today would sound familiar to them. Swings in the terms of trade, the effects of massive international financial events with all their spillovers, policymakers grappling with events they had not seen before, come to mind. They would have seen a need, as should we, for the economics profession to make a constructive contribution to national debate about economic matters. I hope the discussions today and over the course of the conference will help us all to play our parts. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 7 |
Introductory Remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia at the RMB Internationalisation Roundtable, Sydney, 23 July 2014. | Philip Lowe: Australia’s RMB policies and future direction Introductory Remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia at the RMB Internationalisation Roundtable, Sydney, 23 July 2014. * * * I would like to thank Michelle Wright for assistance in the preparation of these remarks. I would like to thank David Olsson and the RMB Working Group for organising today’s Roundtable. It is very encouraging to see the ongoing interest in the topic of RMB internationalisation from both government and business leaders. The Reserve Bank is a strong supporter of the work that is going on and I am very pleased to be able to participate. For anyone interested in international trade or global finance, understanding the issues we are talking about this morning should be very high on their agenda. As I have said before, the internationalisation of the Renminbi (RMB) and the accompanying process of capital account liberalisation in China could well turn out to be one of the seismic events in global capital markets over the coming years.1 Ultimately, this process could see Chinese citizens be able to hold internationally diversified portfolios, just as the citizens of many other countries are already able to do. It could also see citizens from other countries able to buy and sell Chinese financial and other assets with far fewer restrictions than are currently in place. And it could see the Chinese currency become one of the world’s most actively traded. If these things do come to pass, then they would reshape the nature of global capital flows and the international financial system, just as China’s entry into the global trading system reshaped global trade and production. As Australians, we have more than a passing interest in all of this. China is our largest trading partner and our financial linkages with China, while still relatively small, are growing. And by virtue of being a small open economy with an already liberalised capital account, our markets will be affected by changes in global capital flows. So understanding what is going on here is important. This is true not just for those involved directly in the financial sector, but for our society more broadly. I have had the privilege of participating in the first two Australia-Hong Kong RMB Dialogues, the first in Sydney last year and the second in Hong Kong quite recently. From participating in these dialogues my sense is that we are making progress and David Gruen in his remarks has outlined some of the examples. More businesses are genuinely interested in exploring the advantages of having trade invoiced in RMB. The financial infrastructure that supports this trading is gradually being put in place. And some of the stumbling blocks and misperceptions are being eroded. There is, though, much further to travel on this journey. Currently, less than 1 per cent of Australia’s merchandise trade with China is invoiced in RMB. For China, around 12 per cent of total merchandise trade in 2013 was invoiced in RMB, although we estimate the number was around 3 to 5 per cent if trade with Hong Kong is excluded. These figures suggest that there remains significant potential for growth in RMB trade invoicing, not only by Australian firms, but by firms in other countries as well. Australia’s own experience with liberalisation is that the growth of trade makes financial liberalisation easier. As financial markets develop to support trade relationships, those same markets can, in time, support deeper financial relationships. Trade helps deepen financial markets, and deeper financial markets make it easier to liberalise. In the end, though, how Lowe P (2014), “Some Implications of the Internationalisation of the Renminbi”, Opening Remarks to the Centre for International Finance and Regulation Conference on the Internationalisation of the Renminbi, Sydney, 26 March. BIS central bankers’ speeches long this whole journey takes in China is largely dependent upon the pace of reform by the Chinese authorities. It is, of course, also dependent upon the speed with which the financial sector is able to respond to any new opportunities. In part, the development of the appropriate markets depends on commercial decisions made by financial institutions. The Reserve Bank is seeking to play a positive role in this area, partly through helping create a constructive environment in which these decisions can be made. Given this, I would like to spend a few minutes outlining the various elements of our work in this area. First, we have sought simply to better understand how the RMB markets operate. In particular we have sought to understand: the nature of the existing arrangements and products; any impediments to the development of an RMB market in Australia; and how the RMB market sits within the broader financial system. Our representative office in Beijing has been helpful here as have the frequent trips by RBA staff to China. We have also worked closely with the financial sector in Australia, including with the RMB Working Group and have been involved in two separate surveys of corporates’ attitudes toward the use of RMB.2 These efforts have helped us develop a deeper understanding of the issues, as well as understanding in the broader financial community. The joint work has also assisted in providing a forum to support and to coordinate industry-led discussions and initiatives. Second, the RBA has invested some of its foreign currency reserves in RMB. First and foremost, this portfolio shift reflects the growing importance of China in the global economy and the broadening financial relationship between Australia and China. But it has also allowed us to deepen our own understanding of developments in Chinese financial markets and the RMB. Currently, around 3 per cent of our net foreign reserves are invested in RMB. Third, is the bilateral local currency swap agreement between the RBA and the People’s Bank of China (PBC). This swap, which was signed in 2012, allows the two central banks to exchange their local currencies for mutually agreed purposes. The key benefit of the swap agreement is to provide confidence to the Australian market that RMB liquidity will be available through a “backstop” channel in the event of some disruption to the market for RMB. The swap is not meant to provide a “cheap” source of RMB funding to the Australian market in normal times. Its existence, though, should be helpful for market development, as it provides market participants with greater confidence that RMB will be available in Australia during times of dislocation. Since the swap agreement was signed there has not been a need to activate it, although it could be used should it be required. Fourth, the RBA is currently working with the PBC on future RMB clearing and settlement arrangements, in particular the establishment of an “official RMB clearing bank” in Australia. In keeping with the process that has recently been followed in a number of other jurisdictions – including London, Frankfurt, Paris, Luxembourg and Seoul – this would involve the signing of a Memorandum of Understanding between the RBA and the PBC, and the designation of an official clearing bank in Australia. It is important to note that the RBA would not expect to play a significant role in choosing which particular bank would be designated – this is, quite rightly, largely a matter for the Chinese authorities. In terms of timing, we are hopeful that an official RMB clearing bank could be designated over the coming months. The concept of an official RMB clearing bank is one that is sometimes open to some misunderstanding, so I would like to spend a few moments setting out how these institutions The survey in 2013 was coordinated by the RBA, while the 2014 survey was coordinated by the Centre for International Finance and Regulation. The 2013 survey results are summarised in Ballantyne A, M Garner and M Wright (2013) “Developments in Renminbi Internationalisation”, RBA Bulletin, June, pp 65–74. The 2014 survey results are summarised in Centre for International Finance and Regulation (2014), “Internationalisation of the Renminbi: Pathways, Implications and Opportunities”, Research Report, March. BIS central bankers’ speeches operate. In essence, their key function is to facilitate cross-border payments and receipts of RMB for trade-related purposes on behalf of other financial institutions in the local market. Of course, Australian importers and exporters are already able to make and receive crossborder RMB payments through a number of existing channels. For example, Australianbased banks can facilitate cross-border RMB trade transactions through correspondent banking relationships with banks in mainland China, or through RMB clearing “services” that are offered by Australian-based Chinese banks via their mainland Chinese Head Offices. Similarly, these transactions can also be effected through other offshore RMB centres, such as Hong Kong. In fact, the differences between an official RMB clearing bank and the channels that are already available are quite subtle, though still important. In essence, official RMB clearing banks are afforded more direct access to China’s onshore RMB and foreign exchange markets than other offshore institutions. More specifically, official clearing banks have direct access to China’s interbank RMB payments system and receive a quota to transact in China’s onshore foreign exchange market. These changes also entail more direct access to RMB liquidity from the PBC. While an official RMB clearing bank would not directly increase the range or type of RMB transactions that are permitted to take place between Chinese and Australian entities, it would improve the efficiency of cross-border RMB transactions, for example by potentially reducing payment delays and/or reducing transaction costs. And, over time, the presence of an official clearing bank could encourage local financial institutions to offer a broader range of RMB products to the local market than is currently available. Given the way in which the Chinese authorities have chosen to liberalise trading in the RMB, these clearing banks are playing an important practical and symbolic role. Indeed, the establishment of a clearing bank in Australia would help ensure that we are well positioned to participate in the next stages in the process of RMB internationalisation. Ultimately, though, if China does follow the general path travelled by a number of other countries, these clearing banks are likely to become less significant. In other currencies, alternative arrangements exist for the clearing of cross-border flows, with financial institutions managing the liquidity and risk issues without access to an official clearing bank. If this eventually turns out to be the case for the Chinese currency as well, then there is likely to be a reduced need for these official clearing banks. In the meantime, they are an important stepping stone on the path to a more internationally integrated Chinese currency. Finally, a fifth step that we hope to take soon is to obtain a quota for Australian-based financial institutions to invest in mainland China under the Renminbi Qualified Foreign Institutional Investors (or RQFII) scheme. Following the granting of a RQFII quota to a specific jurisdiction, financial institutions operating within that jurisdiction can apply to the Chinese authorities to obtain an individual investment quota. Approved institutions can then invest their own quota in selected mainland Chinese bonds and equities using RMB obtained in the offshore market. In this way, the RQFII scheme can be thought of as representing both a partial relaxation of controls on inward portfolio investment to mainland China and as a means of developing the offshore RMB market.3 An RQFII quota would therefore represent an important next step in facilitating cross-border RMB-denominated investment transactions The RQFII scheme exists alongside two other schemes that allow approved institutions to invest foreign currency in selected mainland Chinese securities: namely, the Qualified Foreign Institutional Investors (or QFII) scheme and a scheme that is commonly referred to as the China Interbank Bond Market (or CIBM) scheme. A number of Australian-domiciled institutions have already received quotas under the QFII scheme, while the RBA’s acquisition of RMB reserves was facilitated under the CIBM scheme. The QFII and CIBM programs differ in a number of respects, including: the types of mainland securities that can be purchased; the types of investors that are eligible to apply; and the mechanisms that are available to convert foreign currency into RMB. BIS central bankers’ speeches between our two economies. And, as Australia has a relatively large and sophisticated private funds management sector, there is significant potential for growth in this area. So, in summary, a lot has been happening, both in the public sector and the private sector. I regard it as very much in our collective interest to continue this work. The changes that could occur in the Chinese financial system over the coming years have the potential to be felt around the world. To benefit from these changes, we need to understand them and be prepared for them. Much of the work that we have been doing has been aimed at identifying and reducing potential impediments to the development of RMB business here in Australia. But once those impediments have been removed – and we are moving closer to that point – the development of the market is very much up to the private sector. Ultimately, in order for the RMB market in Australia to flourish, Australian corporates must be able to identify a clear business case for paying, receiving, lending, borrowing and investing in RMB. Over time, I think this will happen, but there is more work to be done. Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 7 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Brisbane, 20 August 2014. | Glenn Stevens: Overview of economic developments affecting Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Brisbane, 20 August 2014. * * * Chair Members of the Committee Thank you for the opportunity to meet with you today. Since the hearing in March, the global economy has continued its expansion at a moderate pace, and Australia’s trading partner group has been growing at about its long-run average rate. With the abatement of the adverse winter weather, the US economy recovered in the June quarter and the labour market has continued to strengthen. Growth in China has remained close to the target of 7.5 per cent, though Chinese residential property prices have declined in recent months. Chinese authorities at various levels are responding to these developments with the aim of maintaining stable macroeconomic and monetary conditions. In Japan, consumption and output grew strongly in the March quarter ahead of the increase in the consumption tax in April, and then contracted sharply in the June quarter. This is a normal pattern surrounding such tax changes, but complicates reading the underlying pace of Japan’s economy. Economic growth in the rest of east Asia has continued. Commodity prices important to Australia have declined this year, as global supply – including from Australia particularly – has increased. The terms of trade have now fallen by about 18 per cent from their extraordinary peak three years ago, but they remain over 50 per cent higher than their twentieth century trend level. Perhaps the most remarkable feature of the international scene at present is the exceptionally low volatility of financial prices – the lowest observed over the past 25 years for sovereign bonds, equities and foreign exchange. Yields on sovereign debt of the major countries are also very low, the lowest on record in some cases. Spreads on investment grade and financial corporate bonds have reached multi-year lows and in Europe yields on so-called “peripheral” sovereign bonds have in some cases fallen below previous historic lows. It is not as though there has been a dearth of geo-political or financial events which might ordinarily trigger more caution among investors. But compensation for risk on financial instruments remains scant. The reasons for these remarkable trends, including the extent to which they reflect the effects of the exceptional monetary policies being conducted by the major jurisdictions, or other things, could be debated at length. What is clear though is that a combination of forces has resulted in financial conditions remaining remarkably accommodative. This has been reflected in a decline, at the margin, in interest rates in Australia, even though the Reserve Bank has not changed the cash rate for a year. Australian governments have continued to borrow at or around the lowest rates since Federation. Similarly, funding costs for financial institutions have been declining. This, and an increase in competition to lend in an environment of still fairly moderate credit growth, has contributed to a reduction in the rates on housing and business loans. Economic growth was, as recorded, clearly above trend in the March quarter. The quarterly result was, to a large extent, driven by a substantial increase in resource exports, as new mining capacity came on line and mining operations experienced fewer weather disruptions than usual. Data for the June quarter suggest a “payback” of lower exports, and also a period of more subdued consumer demand. There are relatively few readings for the September quarter as yet, though at least some suggest that there may have been a reasonable start to BIS central bankers’ speeches the quarter. Having printed lower for a few months, the rate of unemployment has recently been recorded at a higher level, though most leading indicators of the labour market seem to have improved a little this year. Consumer prices rose by 3 per cent over the year to the June quarter, higher than the pace a year earlier. This partly reflects factors such as the increase in the tobacco excise but measures of underlying inflation also increased. A faster pace of increase in prices for tradable goods and services featured, a reflection of the depreciation of the exchange rate since April last year. The rate of inflation for “non-tradables” has actually declined over the past year, helped by growth of labour costs falling to its lowest rate for many years. There is some evidence that productivity performance may be starting to improve, though this is notoriously difficult to evaluate over periods less than several years. When we look ahead, a key feature of the outlook, as everyone knows, is that the capital expenditure phase of the “mining boom” is winding down, while the export phase is gearing up. The fall-off in investment spending by resources companies has a long way to go yet and will probably accelerate in the coming year. This impending further fall is captivating most of the commentators. Meanwhile growth in non-mining activity has been increasing. A recovery in dwelling investment is well under way, with spending in this area rising by 8 per cent in the year to the March quarter. Forward indicators for non-mining business investment suggest a modest improvement over the coming year, though intentions have remained, to date, a bit tentative. Consumer spending, though soft in mid year, could be expected to grow in line with income, or perhaps a little faster, given the rise in household net worth. But it seems unlikely that households will revert to their behaviour of a decade ago, when they were expanding their balance sheets quickly, saving much less of their incomes and increasing their consumption well ahead of the growth in incomes. Public spending is scheduled to remain quite restrained. The overall growth rate of the economy is the sum of these various forces, and is also affected by factors not confined to the mining sector or even to Australia. Forecasting is an imprecise art at the best of times. At present, given the size of the mining boom, the extent of the shift in global relative prices over the past years, and the very unusual global economic and financial environment in which we still find ourselves, forecasts are likely to be even less reliable. With that caveat, my guess is that over the year ahead the growth of real GDP will be around 2–3 per cent: close to trend, but probably a bit below it in the near term. Further ahead there are some reasons to think that growth could speed up somewhat and be a bit above trend. This outlook would mean that it will be a while before we see sustained reductions in the rate of unemployment. Conditional on the usual set of assumptions about oil prices, the exchange rate and so on, inflation should be consistent with the 2–3 per cent target over the horizon relevant for monetary policy. The depreciation of the exchange rate last year is likely to continue to contribute to higher prices for tradable items for a while yet. But domestic inflation is likely to remain contained given how slowly labour costs have been rising. The removal of the price on carbon will lower inflation temporarily over the coming year. To say that growth is close to trend, but probably a bit below in the near term, will be disappointing to many people. And that is with very accommodative monetary policy – with the cash rate held at its lowest in 50 years for a year now and widely expected to be held at or close to these levels for some time yet. The low returns on offer on safe investments in Australia, and the ultra-low returns on such assets internationally, are certainly having an effect by prompting investors to “search for yield”. Not only are returns on financial instruments low, but yields on the existing stock of physical assets – houses, commercial property, infrastructure assets – are being bid down. Some of that search is of course coming from offshore. BIS central bankers’ speeches That’s a big part of how accommodative monetary policy works. It prompts substitution towards higher-risk assets; it raises asset prices, which increases collateral values and makes credit extension more viable; it improves the cash flows of debtors; and so on. All those things have been happening in Australia. Admittedly, the exchange rate, another channel through which monetary policy usually has an effect, is probably not doing as much as it might usually be expected to do in achieving balanced growth. But the thing that is most needed now is something monetary policy can’t directly cause: more of the sort of “animal spirits” needed to support an expansion of the stock of existing assets (outside the mining sector), not just a re-pricing of existing assets. There are some encouraging signs here. Nonetheless, if reports are to be believed, many businesses remain intent on sustaining a flow of dividends and returning capital to shareholders, and less focused on implementing plans for growth. Any plans for growth that might be in the top drawer remain hostage to uncertainty about the future pace of demand. That’s actually nothing new. It’s pretty normal at this point of the cycle. There is always a period in which people can see that many of the conditions for expansion are in place but aren’t yet fully confident it will happen. Nor is it confined to Australia. The gap between financial risk taking and “real economy” risk taking is seen globally at present. It is reasonable to expect that, at some point, this will change. After all: • not only are funding costs low, but banks want to lend and are competing to do so more actively than they have for some years • net worth per household has risen by about $120,000 over the past two years • the community’s monetary assets have risen by around 13 per cent – over $180 billion – over the same period • productivity improvement in enterprises will presumably continue, and needs to do so. But there are actually a few runs on the board now • the level of gross investment in some sectors is barely above depreciation rates • the population is growing, meaning there will be more demand for housing, infrastructure and consumer goods and services • the dynamic of proximity to a rising Asia, with all its opportunities, remains. Business will need to respond to trends that foreshadow sustainable increases in demand and incomes. Not all that response will come from the large established players; a significant proportion will come from smaller and newer players, most of which operate “below the radar”. The financial capacity to provide credit prudently will help them do so. At some point, if these responses start to gather pace, the sorts of forecasts we are setting out at the moment will very likely prove to be conservative. The frustrating thing is that no one can say when that will happen, or just what might be the proximate trigger. In the interim, monetary policy’s contribution to this process is to lend support to demand, consistent with its obligations to seek full employment and price stability as set out in the inflation target, and taking due account of financial stability considerations. This has resulted in very low interest rates, and as noted earlier financial conditions in Australia have in fact eased a little over recent times even though the cash rate has not changed. In reaching its decisions, the Board has been mindful of allowing time for measures already taken to have their effects, and of the very considerable limitations for monetary policy in fine-tuning economic outcomes over short periods. It has also seen some value, in the present circumstances, in maintaining a sense of steadiness and stability. My colleagues and I await your questions. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 8 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Committee for Economic Development of Australia (CEDA) Luncheon, Adelaide, 3 September 2014. | Glenn Stevens: The economic scene Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to Committee for Economic Development of Australia (CEDA) Luncheon, Adelaide, 3 September 2014. * * * Thank you for the invitation to visit Adelaide. As you know the Reserve Bank Board met here yesterday and decided to leave the cash rate unchanged. The statement issued after the meeting gave the reasoning for the decision, in the usual concise fashion. Today I will give some broader remarks about the global and domestic economies and financial conditions. The global economy has continued its expansion this year. Estimates for global growth are running at about 3¼–3½ per cent. This is a bit better than the 2013 outcome and close to, albeit a little below, the three-decade average, which is 3.6 per cent. We are now in September, so unless something pretty dramatic happens soon in one of the large economies, those estimates should be a pretty accurate guide to the annual outcomes. For Australia’s particular group of trading partners, weighted by export shares, growth is running at about 4½ per cent, which is somewhat above the 30-year average. This strength reflects the continued increase in the weight of China as a destination for exports. Even though China is growing more slowly than it used to – at a mere 7½ per cent this year – the fact that its growth is so much stronger than most others combines with its increased weight to push up the weighted-average growth of our trading partner group. The determined pessimists among us will see the increased weight of China as a concern: what if something goes wrong and the Chinese economy experiences a sharp slowing in growth? In fact this is a question that could be put for most economies now – nearly 50 economies, including the United States, European Union, Japan, Russia and Canada, now have China as their number 1 or 2 trading partner. The full ramifications of the continuing rise in the weight of China’s economy and, in time, its financial system in world affairs will be the topic for numerous lengthy books. But in short, the whole world is now more dependent on China than it was. For today, probably the most important point to note is that the near-term task of the Chinese authorities is to manage the desired slowing in credit growth and moderation in asset values. Housing prices are falling in many Chinese cities at present. This is not unprecedented – it is the third time in the past decade this has occurred. (Yes, house prices can fall, even in China.) This area – the asset price and credit nexus – is the one to watch, more than the monthly exports or PMIs and so on. One of the most remarkable features of the international scene is the exceptionally low volatility of financial prices and the compression of risk premia. Yields on sovereign debt of the major countries are very low, the lowest on record in some cases. Spreads on investment-grade and financial corporate bonds have reached multi-year lows. Nowhere is this phenomenon more striking than in Europe. Two years ago, some major European countries faced a crisis of sovereign credit. Their governments were experiencing borrowing rates that suggested that markets had very serious questions about their budgetary sustainability. Now, these same countries are borrowing more cheaply than they did in 2007, prior to the eruption of the crisis – even though they are now carrying considerably more debt than they were back then.1 There is obviously the potential for multiple equilibria here. If market participants think debt is unsustainable, and borrowing costs correspondingly rise, that itself can be the thing which makes the position unsustainable. BIS central bankers’ speeches Corporate borrowing costs are similarly low. Investment grade bonds in the US and euro area and Australia are yielding only around 100 basis points more than the equivalent government bonds and even “junk” bonds from these countries are, on average, yielding around 6 per cent or less. Some entities (Graph 1) have issued debt with 50 or even 100year maturities. Given the uncertainty about the state of the world over that horizon, the returns on offer to investors in financial claims seem strikingly low.2 Graph 1 Another pricing puzzle is exchange rates. Many in Australia have commented at length about the relatively high value of the Australian dollar against the US dollar. The Bank has made its views on this pretty clear and so I won’t reiterate them today. But it’s worth noting that many other countries have had a similar puzzle to ours – so the real question is why the US dollar has remained as low as it has. Overall then, the global environment remains “interesting”, with significant challenges, uncertainties and puzzles. All that said, from Australia’s point of view, the world economy continues to grow, inflation remains contained, our terms of trade though falling remain high, and financial conditions are remarkably accommodative. On the domestic front, we had the latest estimates of national income and spending today. The latest quarter was expected to be one of slower growth than the preceding one, which had been quite a strong one, in part because of some temporary factors which could not continue. Taking the two quarters together suggests a picture of moderate growth. There will no doubt be a huge amount of breathless analysis of these data and intense speculation about what they mean. It will be worth remembering to take a step back and look at the longer perspective. In that spirit, allow me to offer an update of a chart from a speech I gave here two years ago (Graph 2). If the stock of public debt is, say, 100 per cent of GDP or more, and the rate of interest is 6 per cent rather than 3 per cent, that amounts to 3 per cent of GDP per year in additional servicing costs. Few governments could easily manage an increase in servicing costs of that size. How many such entities will exist in their current form when such debts fall due is an interesting question. Of the 30 companies that were included in the Dow Jones Industrial Average in 1964, about half had disappeared through merger, buyout or bankruptcy by 2014. BIS central bankers’ speeches Graph 2 Compared with last time I showed you this, it is pleasing that the US and the UK have recorded some solid growth, and New Zealand – one of Australia’s closest trading partners – has been growing particularly well, as the task of re-building much of their second largest city gets into full swing. Some of these countries have been recording growth faster than ours lately. That they have sped up, and may even be starting to close the gap, should be welcomed. This chart was prepared prior to today’s data so the line for Australia is not quite up to date. Even so, there is still not much doubt about which country, among this group, has had the most consistent performance. Of course these data are already somewhat dated. We can ask what has been happening more recently. The answer is that growth is continuing. Most survey indications are that business conditions have improved a little, and that household sentiment has recovered a fair bit of the fall seen in April and May. Those measures are close to average. We have seen the unemployment rate print higher in July, after several months where it had not changed much. Because of measurement issues, interpretation of that monthly figure is even more hazardous than usual, and this may remain so in the months ahead. Nonetheless, the data cannot be dismissed and are, on their face, concerning. Other indicators have mostly suggested a slight improvement in the labour market this year, not an accelerating deterioration. The Bank’s reading, which we have had for a while, is that the labour market has a degree of spare capacity, and that it will be a while before we see unemployment decline consistently. Looking ahead, ideally, the non-mining part of the economy would see a further pick-up to grow a bit above trend for a while, having been below trend for a while up to recently. We may not be quite there yet, but we are I think slowly building a foundation for better performance. What can we do to help this? The main thing the Reserve Bank can do is run an accommodative monetary policy so as to lend support to demand in the non-mining areas of the economy. Rates of interest are at very low levels, and have been steady there for over a year now. Most observers expect they will be there for some time yet. The rate we actually set, the overnight rate, is as low as it has been on a consistent basis in my lifetime. Rates of interest that matter more for most borrowers are similarly very low, and in fact have been declining slightly even though the Reserve Bank Board has not changed the cash rate for BIS central bankers’ speeches over a year now. They are lower than in recent previous cycles, even though the economy today is nothing like as weak as it has been on most of those occasions. Monetary policy doesn’t just work on the borrowers; the savers or investors matter too (and in fact there are more of them). The low returns on offer on safe investments in Australia, and the ultra-low returns on such assets internationally, are certainly having an effect by prompting investors to “search for yield”. Not only are returns on financial instruments low, but yields on the existing stock of physical assets – houses, commercial property, infrastructure assets – are being bid down. Some of that search is of course coming from offshore. That’s a big part of how accommodative monetary policy works: by prompting substitution towards higher-risk assets; raising asset prices, which increases collateral values and makes credit extension more viable; improving the cash flows of debtors; and so on. All those things are quite normal parts of the so-called “monetary transmission mechanism”. In some ways that term is a misnomer because while some of the “transmission” is somewhat mechanical, a lot of it isn’t. It depends on the behaviour and general frame of mind of the myriad households, businesses large and small, investors and financial market players and so on. The final linkages in the “mechanism” are those that connect changes in financial behaviour to changes in spending on real goods and services. And while high enough interest rates really can, more or less, force people to curtail their borrowing and spending, low rates can’t make them borrow and spend. They have to want to. The power of monetary policy to boost domestic demand depends importantly on some sectors of the economy being in a position to respond to lower costs of debt, higher collateral values, reduced incentives to save and so on, by spending more today, with confidence that their income in the future will allow them to service and repay the debt. Which sectors would be available to lead such an expansion? In the broad, there are three. There are households, governments and firms. Let’s think about each briefly. Households being willing to increase their debt and lower the share of current income being saved was a striking feature of Australia’s economic landscape from the early 1990s until just prior to the financial crisis. Consumption spending consistently rose faster than income and the ratio of debt to income went from about 60 per cent in 1993 to 150 per cent by 2006. Households are servicing that higher debt quite well – mortgages make up most of their debt and arrears are running at about one half of 1 per cent, which is low by global standards. But as I have argued before, it seems unlikely that household debt can rise like that again. Nor would it be desirable. So while we can expect that household consumption spending can grow in line with income, or maybe a little faster given the rise in net worth over the past two years, the odds are against households being a driver of strong growth the way they were a decade ago. What about the government sector? Most governments in Australia are trying to strengthen their own balance sheets by containing the build-up in debt that has been occurring.3 Public final spending is scheduled, according to the stated intentions of federal and state governments, to be subdued over the next couple of years. In fact, it is forecast to record the most subdued growth for a long time. By and large then, the public sector is not in the phase of using its balance sheet to expand demand faster than normal. Here it is worth noting that proposals to fund infrastructure spending by “asset re-cycling” still amount to a fiscal stimulus, other things equal. Selling assets for this purpose is a financing device just like selling bonds. In one case the private sector is absorbing a real asset; in the other it is absorbing a financial claim on the government. Either way, the private sector is transferring financial resources to the government, who is then going to use those resources to acquire goods and services. In one case the government has less debt on its books, though also less assets. The effect on aggregate demand is the same. BIS central bankers’ speeches That leaves the business sector. What can we say about its balance sheet? The business sector is of course very diverse. But in the broad we can observe that its leverage is mostly low, and probably lower than it was a decade ago in most instances, in contrast to either households or governments. It also seems that holdings of cash have been increasing of late (Graph 3). The available data from the listed company sector show a modest increase, leaving aside the resources sector. Looking at data from the financial aggregates, we can compare the evolution of business credit and business holdings of deposits and like products, over time (Graph 4). Graph 3 Graph 4 BIS central bankers’ speeches This data includes fund managers’ holdings of cash assets, which from other data appear to have risen by close to $200 billion since 2006. But overall, this comparison suggests a very marked improvement in the liquidity of the business (and fund management) sectors’ balance sheet over the past five years. My conclusion would be that many businesses are in a position to play their part in the growth dynamic over time. The fact that in some areas outside of mining the level of gross fixed capital spending is barely above depreciation rates suggests that, over time, capital spending in those areas will have to increase. The forward estimates of non-mining business capital spending released recently do show a further upgrading of intentions. That won’t offset the impending fall in mining investment and it would be good to see further, and more substantial, upgrades over time. But the available data suggest that things are at least heading in the right direction. This is not some call for business leaders to play a role in driving growth out of a publicspirited desire to help the economy. That would be a fruitless call because doing that isn’t their job. Their responsibility is to run their companies in the interests of the companies’ owners. My argument simply is that, at some point, it is going to be in the interests of the owners for investment to take place in new technologies, better processes, new lines of business and, in time, more capacity. At some stage, the equity analysts, shareholders, fund managers, commentators and so on will want to be asking not “where’s your cost cutting or capital return plan?”, but “where’s your growth plan?” As business responds to trends that foreshadow sustainable increases in demand and incomes, some of the response will come from smaller and newer players. Some of these will probably be among the most innovative enterprises. There isn’t much focus on what these entities are doing in the general commentary on the economy, perhaps because there are fewer established data sets. Measuring innovation and so on is less straightforward than measuring how many building approvals were issued in any given month. But my suspicion, admittedly based on some rather indirect measurement, is that innovation is occurring. For example, according to a regular ABS survey on innovation in Australian companies, the trend over recent years is for more companies to be developing innovations and fewer to be abandoning attempted innovations (Graph 5). We can also observe that growth in labour productivity per hour has picked up in the past couple of years, which suggests changes to practices in work places. And one crude gauge of “animal spirits” – the number of new companies registered with ASIC – has been rising quite strongly since 2011 (Graph 6). No doubt there are all sorts of reasons for registering corporate entities, but perhaps this shows that there are some out there taking a risk.4 And in the end, that’s the vital ingredient for private sector growth. We might also look at how many patent applications are occurring. It appears that they increased strongly in 2013, but this was due to a change in legislation triggering a rush in applications just prior to new arrangements taking effect. So the underlying trend is not clear. See http://www.ipaustralia.gov.au/uploadedfiles/reports/intellectual-property-report-2014-low-res.pdf. BIS central bankers’ speeches Graph 5 Graph 6 Having talked a little about what monetary policy can do to help the current situation, I need to be clear that there are also things that it can’t do, and some things that it shouldn’t do. Monetary policy can create conditions of easier funding and help the ability of the financial sector to extend credit. But it can’t, for example, add to the supply of land zoned for housing, or improve the responsiveness of the construction sector to demand for additional housing stock. Other policies have to do that – and it’s important that they do if we are to see easy credit result in more dwellings as opposed to just higher prices for the existing dwellings. Monetary policy can’t create the additional infrastructure that most people agree we need. Funding conditions are not, in fact, an impediment to infrastructure. The real issues are governance, risk-sharing and pricing – areas where other policies have to be right. Monetary policy can’t directly cause the innovation and technological change that is so important for BIS central bankers’ speeches wellbeing of our citizens over time. Other policy areas have to be right – and then the innovators and their backers have to be willing take the necessary risk. As for things that monetary policy should try to avoid, we are also cognisant of the fact that monetary policy does work initially by affecting financial risk-taking behaviour. In our efforts to stimulate growth in the real economy, we don’t want to foster too much build-up of risk in the financial sector, such that people are over-extended. That could leave the economy exposed to nasty shocks in the future. The more prudent approach is to try to avoid, so far as we can, that particular boom-bust cycle. It is stating the obvious that at present, while we may desire to see a faster reduction in the rate of unemployment, further inflating an already elevated level of housing prices seems an unwise route to try to achieve that. Conclusion The future has no shortage of challenges, but that is hardly new. Sensible policies in many areas are needed to help with the required adjustments. That includes monetary policy, within the limits of its powers. A very accommodative interest rate structure, and a degree of stability and predictability, has been in place for some time now. Indeed the conduct of policy could perhaps be described as boring. If so, I would regard that as a small success. While the financial markets like to think about almost nothing else than what will happen to interest rates next month, I suspect most people are happy not to have to think about such things, and prefer focusing on issues of more enduring importance for their business or their lives. And it’s those things that, well attended to, will deliver our future prosperity and wellbeing. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 9 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Bloomberg Economic Summit, Sydney, 16 September 2014. | Christopher Kent: Non-mining business investment – where to from here? Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Bloomberg Economic Summit, Sydney, 16 September 2014. * * * I thank Lara Bui, Natasha Cassidy, Bernadette Donovan, Stephen Elias, Craig Evans, Gianni La Cava, Kevin Lane and Tom Rosewall for help in preparing these remarks. Accompanying graphs can be found at the end of the speech. Introduction I’d like to thank Bloomberg for the opportunity to talk to you today. I discussed this topic at this same venue 18 months ago. The outlook for non-mining business investment is an important element of our forecasts. It depends on a range of forces acting on the economy, including the stimulus currently being provided by the very low level of interest rates. But, forecasting economic activity is hard. Understanding and forecasting business investment is arguably harder still. When I was here in April of last year, I’d suggested that: • mining investment would be likely to peak in 2013; • non-mining investment would be likely to pick up, but only gradually; and • growth for the economy as a whole would be a little below trend in 2013 and then pick up gradually through 2014. It now looks like mining investment peaked in late 2012 (Graph 1). Despite a substantial decline in mining investment since then, growth of the economy overall picked up to a pace that was around trend over the course of the past year. Much of that improvement has owed to a sharp rise in resource exports. At the same time, there has also been an improvement in the growth rate of economic activity in the non-mining sectors, even though non-mining business investment has remained subdued. This better growth of non-mining activity often gets missed given all the focus on the resources boom. While this improvement is welcome, a key question is how durable the improvement will be? It might even gather a bit more steam, thereby helping to drive overall growth to an above-trend pace at some point. Such developments are possible but by no means certain. They depend in part on non-mining business investment, which is the motivation for my talk today. Recent past Over recent years, non-mining business investment has been subdued. After recovering from the decline that followed the global financial crisis, non-mining business investment in real terms has been little changed over the past three years or so (Graph 2). In nominal terms, non-mining business investment is at a very low level as a share of GDP relative to its history. 1 It is worth noting that the period of weak non-mining investment up to 2012, and non-mining activity more generally, allowed for the unprecedented mining investment boom without leading to excess aggregate demand and all of the problems associated with that. BIS central bankers’ speeches Non-mining business investment should depend, in large part, on the strength of expected demand in the non-mining sectors of the economy (over the life of that investment). Current demand conditions, however, may have a strong influence on investment for two reasons. First, firms tend to draw on recent experience when assessing prospects for future demand. Second, stronger sales today will boost current cash flows, which will assist firms facing financial constraints. Hence, the gradual pick-up in the growth of non-mining economic activity over the past year augurs well for investment. Low interest rates and robust population growth are underpinning strong demand in the housing market, with house prices rising rapidly and dwelling investment picking up strongly. Low interest rates are also supporting growth of consumption at a time when subdued conditions in the labour market are weighing on the growth of incomes. These developments, as well as growth in export industries such as tourism and education, are consistent with a pick-up in business conditions across a range of industries. Despite these gains, survey measures of non-mining capacity utilisation have not improved much over the past year. A measure derived from the NAB survey (based on weighting industries according to their contribution to investment) implies that capacity utilisation remains a bit below average (Graph 3). By itself, this suggests that demand in the nonmining sector will need to rise a little further before businesses feel the need to undertake substantial investment in new capacity. Our forecasts for the economy suggest that this will occur in time, but the extent and timing of new investment remains uncertain. It’s not just output/demand that matters In addition to the strength of demand, a range of other factors also influence investment decisions. In particular, investment depends on whether the expected return to new capital outweighs the cost of installing it. In other words, a firm should invest whenever the market value of its existing capital is greater than its book value. This is known, in academic circles, as Tobin’s Q theory of investment, where Q is the ratio of the market value to the book value of capital. It turns out that empirical support for the relationship between investment and the Q-ratio is weak for the economy as a whole. 2 However, it is possible to show that such a relationship exists at the level of individual firms (Graph 4). Estimates from Tobin’s Q type models based on Australian firm-level data indicate that non-mining investment has been unusually weak by historical standards in recent years. This is true after controlling for many other factors typically included in such models, such as sales growth and cash flows. For firms in the Bank’s liaison program, it also appears that investment has been weaker than the recent growth in sales would suggest. With that in mind, let’s consider some possible explanations for the weakness in non-mining business investment, and what that might imply for the outlook. The poor performance of Tobin’s Q models is quite common in the literature. For a discussion of some of the problems, see Chirinko R (1993), “Business Fixed Investment Spending: Modeling Strategies, Empirical Results and Policy Implications”, Journal of Economic Literature, 31(4), pp 1875–1911. For a more recent discussion, see Roberts M and T Whited (2013), “Endogeneity in Empirical Corporate Finance”, Chapter 7 in the Handbook of Economics of Finance, 2A, pp 493–572. The results of estimating these types of models on aggregate Australian data have been generally disappointing (for instance, see Cockerell L and S Pennings (2007), “Private Business Investment in Australia”, RBA Research Discussion Paper No 2007–09). Some studies that use firm-level data have had some success in modelling investment using the Q ratio, but even these results are sensitive to certain modelling choices (see, for example, La Cava G (2005), “Financial Constraints, the User Cost of Capital and Corporate Investment in Australia”, RBA Research Discussion Paper No 2005–12). BIS central bankers’ speeches The cost of borrowing remains too high and external finance is difficult to access? My discussion so far has ignored the fact that firms face financing constraints of varying degrees and certain types of finance are more costly to obtain than others. In particular, the cost of external equity finance is typically greater than the cost of external debt which, in turn, is greater than the cost of internal funding. Financial constraints certainly became more pervasive for many firms as the global financial crisis unfolded. However, those constraints have eased over time. More recently, external financing has become widely available at very favourable cost. Primarily, this reflects the stance of monetary policy (both in Australia and abroad), which is delivering historically low levels of interest rates, ample liquidity and has helped to push up equity prices. Indeed, a common refrain of firms in the course of our business liaison has been that neither the cost nor the availability of external finance have been factors limiting investment of late. Moreover, (non-financial) corporate balance sheet data indicate that many Australian companies currently hold relatively high levels of cash, suggesting that they have access to resources to finance investment when the time comes. The exchange rate is too high? The exchange rate has declined somewhat relative to its peak in the first half of 2013. But it remains high, especially given the sizeable decline in commodity prices this year. The implications of this vary across traded and non-traded sectors. A further decline in the exchange rate would provide additional support to demand for domestic firms producing tradable goods and services. At the same time, however, the high exchange rate also means that imported capital goods are currently relatively cheap. Hence, the still-high level of the exchange rate may be a net positive factor for the investment plans of some firms in non-tradable industries. For firms in tradable industries, on the other hand, the low cost of imported capital is offset by the effect of the high exchange rate on the demand for the goods and services they produce. In short, the high exchange rate might be playing a part in restraining investment in some sectors of the economy, but it’s unlikely to be the full story. Animal spirits are too weak? What is often referred to as “animal spirits” consists of three key elements. 3 First, there is uncertainty, which describes the range of possible outcomes, let’s say for demand, but other things like costs matter too. Second, there is the expected or most likely outcome. Together, these describe the distribution of possible outcomes. But firms’ willingness to invest also depends on the third element, which is their appetite for risk. I’ll consider each of these elements in turn. The outlook is too uncertain? On the surface, uncertainty seems like an appealing explanation for subdued investment. However, we should remember that firms always have to make investment decisions in an environment of uncertainty, not just about the prospects for the macroeconomy but also for their industry. Rather, the question we need to ask is whether uncertainty in recent years has been elevated? For a detailed discussion of the difference between these concepts, see Haddow A, C Hare, J Hooley and T Shakir (2013), “Macroeconomic Uncertainty: What is It, How Can We Measure It and Why Does it Matter?”, Bank of England Quarterly Bulletin, 53(2), pp 100–109. BIS central bankers’ speeches There are a number of ways that we might try to measure the extent of uncertainty. One measure is the volatility of firms’ share prices (Graph 5). 4 Another is the dispersion of analysts’ forecasts of firms’ earnings (per share). A third can be constructed by looking at the proportion of news stories that mention uncertainty. 5 These measures all increased at the time of the global financial crisis. All of the measures have since declined to be around the levels seen prior to the financial crisis, when non-mining business investment had been growing strongly. 6 Expectations regarding demand are too weak? Even if uncertainty about the range of possible demand outcomes is not too different from the past, the most likely outcome – the mean of the distribution – might still be too weak to lead to significant new investment projects. Business surveys ask firms what they expect conditions will be like in the near future; the results are described as “business confidence”. The long-running NAB survey suggests that business confidence was in decline and below its long-run average up to the middle of last year (Graph 6). Since then, it has picked up noticeably. This improvement was shortly followed by a broad-based pick-up in the survey’s measure of actual business conditions (that is, trading conditions, profits and employment). According to the NAB survey, and a number of other business surveys, business confidence and conditions are now above average. However, our liaison program suggests that businesses generally remain reluctant to take on significant new investment projects until they can be confident of a more sustained improvement in demand conditions. How long do conditions need to hold at above average levels before the improvement is considered to be sustainable? We don’t know the answer to this. In part, this is because animal spirits are by no means mechanistic or predictable. What matters for your investment plans is not just what you think about the future, but what you think your competitors think about the future. In part, this is because if your competitors are less than enthused about investing, the pressure for you to invest to avoid being left behind is lessened, and vice versa. Elevated risk aversion? Even though measures of uncertainty appear to have declined, and firms’ confidence about future business conditions is above average, firms’ investment plans may sit idle if they are more risk averse than in the past. (By firms, I mean both managers and shareholders alike.) It’s clear that firms became more risk averse at the onset of the global financial crisis. It seems that they remain affected by that experience. While the direct effects of the crisis on the Australian economy were generally short-lived and relatively minor compared with the experience of many economies, the events of that time led many Australian businesses and households to re-evaluate their appetites for risk. The household sector increased its saving rate noticeably at the time of the crisis and it remains around the more prudent levels that The measure in the top panel of Graph 5 is the S&P-ASX “VIX Index”, which is based on option pricing data and measures expected levels of near-term volatility in the Australian equity market; it includes mining sector stocks. For details of the methodology, see Baker S, N Bloom and S Davis (2013), “Measuring Economic Policy Uncertainty”, unpublished manuscript, available at <policyuncertainty.com>. One thing that businesses often cite as a concern is uncertainty about various policies affecting different industries. It’s hard to judge, though, the extent to which that source of uncertainty is greater today, if at all, than it was in the past. BIS central bankers’ speeches had been the norm in earlier decades. 7 Also, businesses deleveraged and have built up their levels of cash holdings. One measure of firms’ appetite for risk is their “hurdle” rates of return. These serve as rules of thumb for firms to evaluate whether or not to proceed with a particular project. The higher the hurdle, the less likely any given project will be given the go ahead. There is no evidence that hurdle rates of return have increased over recent years. But neither is there evidence that they have declined even though the average cost of capital for firms has fallen.8 This larger gap between the hurdle rates and the average cost of capital implies a reduction in firms’ appetite for risk. This result, which is consistent with information from our liaison program, appears to be a global phenomenon. Our liaison provides other evidence of a more cautious approach to investment over recent years. In particular, many firms now require investment projects to satisfy shorter payback periods and be approved at higher levels of management than was typical in the past. 9 Other longer-term determinants? The current weakness in non-mining business investment may reflect the effect of some longer-run determinants of investment. One such candidate is (multifactor) productivity growth. Relatively weak growth of productivity over much of the past decade would have weighed on the return to capital and reduced the incentives to add to the capital stock in nonmining industries (Graph 7). (In principle, this effect should already be reflected in levels of Tobin’s Q.) If productivity growth were to remain relatively low, that would weigh on overall growth of the economy. Low growth of investment would naturally follow from low productivity growth, but it would not be the cause of weak growth of the overall economy. In any case, it’s hard to know exactly what productivity growth is likely to do in the future. More recently, multifactor productivity growth appears to have increased a little. It is currently not far from growth rates seen prior to the mid 1990s, which was a period of especially rapid growth. In summary, some of these explanations have more merit than others. External finance is generally readily available and at very low cost, so this can’t explain the weakness in nonmining business investment. Looking at the available data, it’s hard to argue that heightened uncertainty is playing much, if any, role. Rather, some combination of relatively low growth in domestic demand, the effects of the high exchange rate, a lack of confidence and a lower appetite for risk (than in the past) appears plausible. There are some metrics consistent with this, and it aligns too with what businesses say is holding them back. What do the data suggest about the future? The Australian Bureau of Statistics capital expenditure (“Capex”) survey provides a measure of firms’ investment plans for up to 18 months ahead. 10 The saving rate has drifted down a little over the past couple of years, and the stronger growth of household credit of late suggests that there has been some pick-up in the appetite for risk among households. For a discussion of the experience of US firms, see Sharpe A and G Suarez (2014), “The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs”, Finance and Economics Discussion Series, Working Paper 2014–02. In a related vein, there is evidence that Australian listed companies have more risk-related meetings now than in the early 2000s. It’s possible that this is a response to an increased compliance burden, though such a change may have reduced firms’ appetites for risk nonetheless. (Special thanks to Gianni La Cava for suggesting this measure and to Lara Bui who painstakingly constructed it.) The survey needs to be adjusted for the fact that realised investment tends to vary predictably from what is initially expected by firms. There are various ways to do this. For forecasting purposes, the most reliable method is to adjust investment expectations by the average “realisation” ratio over the full history of the BIS central bankers’ speeches The most recent survey implies a modest increase in nominal non-mining business investment in 2014/15, in the order of 4½ per cent. The survey suggests that investment is likely to rise for a number of industries, including: rental hiring and real estate; information media and technology; retail; and construction. This picture is consistent with the ongoing recovery in household expenditure, including on dwelling investment, and in non-residential building construction. Investment is expected to decline in the manufacturing sector and for utilities. Given that firms adapt their plans as events unfold, the early readings on investment intentions for a given year often turn out to be wrong. We can see the extent of this by comparing the early estimates for a given year with the final (seventh) estimates in the Capex data. This is shown here based on the third estimate, which is what we currently have to hand for this financial year (Graph 8). We can see that even over the course of just a few quarters, business investment can turn out to be quite a bit higher, or quite a bit lower, than the most recent reading from the survey suggests. For example, investment covered by the Capex survey was much weaker than had been expected initially through the 1990s recession and early 2000s slowdown. But it was stronger than initially expected through the mid 2000s and a bit stronger than expected last financial year. In short, if firms decide to undertake more investment than they had earlier anticipated, that investment can come about relatively quickly. Conclusions In conclusion, non-mining business investment has been subdued and measures of capacity utilisation remain a bit below average levels. Meanwhile, over the past year or so there has been a gradual increase in the pace of growth of economic activity outside of the mining sector, owing in part to the very low level of interest rates. Subdued investment (outside the mining sector) has been consistent with a period of greater uncertainty and below-average confidence. However, a number of indicators suggest that uncertainty has declined to levels seen prior to the global financial crisis. Also, measures of business confidence have picked up over the course of the past year to be a bit above longrun average levels. While this is a welcome development, it may not be sufficient to spur investment if businesses’ appetite for risk remains relatively low. Moreover, the still-high level of the exchange rate may be weighing on investment of firms in the traded sector. Nevertheless, there are tangible indications that non-mining business investment will grow at a modest pace this financial year. And if firms’ willingness to take on risks improves, investment could easily be stronger still. It’s always hard to know if and when such a change in sentiment might occur. But it is more likely to do so when the fundamental determinants of investment are in place. The ready availability of internal and external finance, at very low cost, is one element of that. The stronger growth of demand across the non-mining parts of the economy over the past year or so is another. If history is any guide, eventually the period of elevated risk aversion is likely to give way to a concern among businesses, not of losses, but of lost opportunities and a loss of market share. survey; for details, see Berkelmans L and G Spence (2013), “Realisation Ratios in the Capital Expenditure Survey”, RBA Bulletin, December, pp 1–6. It is also worth noting that the Capex survey provides only a partial read on non-mining business investment because it excludes firms from a number of key industries, including agriculture, health care and education (which accounted for about 16 per cent of private non-mining business investment in 2012/13) and it excludes investment in intangible assets (which accounts for about 15 per cent of total private business investment). BIS central bankers’ speeches Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches Graph 5 Graph 6 BIS central bankers’ speeches Graph 7 Graph 8 BIS central bankers’ speeches | reserve bank of australia | 2,014 | 9 |
Opening remarks by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, and Ms Luci Ellis, Head of Financial Stability Department of the Reserve Bank of Australia, at Inquiry into Affordable Housing, Canberra, 2 October 2014. | Malcolm Edey: Inquiry into affordable housing Opening remarks by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, and Ms Luci Ellis, Head of Financial Stability Department of the Reserve Bank of Australia, at Inquiry into Affordable Housing, Canberra, 2 October 2014. * * * Thank you, Chair, for the opportunity to discuss the Reserve Bank’s views on this important topic of housing affordability. This is a subject on which the Bank has published a good deal of analysis over the years. I will refer in particular to our submission to this Inquiry in February, and also to our most recent Financial Stability Review, released last week, which covers our assessment of current developments. My colleague Luci Ellis was the author of the February submission and she will be happy to answer any detailed questions on its contents in due course.1 In these opening remarks, I will be drawing on some of the key points from those two sources. There are a number of things that people might have in mind when they use the term “affordability”. Affordability measures will differ depending upon whether we are talking about owners or renters, and on whether we are interested in some specific market segment, like first home buyers or low-income households. For owner-occupiers, perceptions of affordability will depend on many things including price, household income, the cost and availability of finance, and a host of factors affecting the needs and aspirations of the buyer. In any analysis it is necessary to make use of summary measures, while acknowledging that these inevitably gloss over the diversity of experience across different types of households. Much of the public discussion on affordability is focused on home purchasers. A useful summary measure is the repayment on a typical new housing loan expressed as a ratio to disposable income. On that metric, housing affordability in Australia has fluctuated around a broadly stable average over the past three decades, with average repayments varying between around 20 and 30 per cent of disposable incomes. These data are reported in our submission. Currently this figure is a bit below average, but it has been rising in the period since the publication of the submission, as the housing market has gathered momentum. Over the same 30-year period, the ratio of housing prices to incomes has increased substantially. These developments in prices and affordability have been inter related. Housing prices received a substantial boost from the combined effects of disinflation and financial deregulation, which lowered the cost and increased the availability of finance. Much of the increase in the price-to-income ratio was concentrated over the 10-year period to the end of 2003, when this ratio increased by around two-thirds. It is reasonable to think of this as a transitional impact on housing prices that will not reoccur. Both the shift to low inflation, and the comprehensive deregulation of the financial system, are things that only happen once. In broad terms, the adjustment of the housing market to this new environment seems to have been completed by around the middle of the last decade. Since then, the ratio of housing prices to incomes has been relatively stable but, for reasons already alluded to, it has been rising recently and is now at the upper end of its recent range. I will return to this point in a moment. To summarise these stylised facts: • the ratio of housing prices to incomes is at the top of its historical range; but RBA 2014, Submission to the Inquiry into Affordable Housing. Submission to the Senate Economics References Committee, February. BIS central bankers’ speeches • over time, this has been more than offset by falls in financing costs, so that the typical repayment burden as a share of income is not particularly high. This of course does not rule out affordability problems in particular market segments or for particular types of households. Our submission made the point that there is no shortage of housing finance in Australia. Housing loan interest rates are currently as low as they have been in a generation, and households are not artificially constrained from borrowing as much as they can reasonably be expected to repay. I have already made the point that perceptions of affordability will differ across different types of households; but, if there is a perceived affordability problem in Australia, it is not due to a lack of finance. An important theme of our submission was that housing prices and affordability are affected by the interaction of both supply and demand factors. The factors that I have mentioned so far, such as household incomes and the cost and availability of finance, primarily affect the demand side of the market. In the short to medium term, it is these factors that will tend to have the predominant influence on housing price movements. The reason for that is that the supply side of the market is dominated by a large existing stock of dwellings, and new supply takes time to come on stream. In the longer term, however, supply factors are critically important. It is the supply response that determines the extent to which additional demand results in higher prices over time. Our submission highlights that Australia faces a number of longstanding challenges in this area, including regulatory and zoning constraints, inherent geographical barriers and the cost structure of the building industry. There are also obstacles to affordable housing created by Australia’s unusually low-density urban structure, though this is gradually changing. Our submission does not seek to offer policy prescriptions for improving the supply-side response. The general point I would make is that we can’t improve housing affordability simply by adding to demand. Targeted assistance can certainly help particular groups such as first home buyers, but without a supply-side response, any generalised increase in demand will just be capitalised into prices. Hence an important emphasis in our submission is that due attention needs to be given to supply-side factors in any policy response to perceived problems of affordability. Let me turn now to some current developments. I have already mentioned the recent strength in Australian housing prices and I expect the Committee will be interested in the Bank’s current assessment of this, particularly in light of the comments made in our Financial Stability Review last week. Over the past couple of years, housing prices in Australia have been rising strongly. Some of this perhaps represented an element of “catch up” after some earlier weakness. Nonetheless, prices have continued to rise significantly faster than incomes, and this has been associated with strong growth in investor activity. To cite a few key facts and figures: • National housing prices have been rising at a rate of around 10 per cent over the past year, and around 15 per cent in Sydney. • The rate of growth of investor finance is significantly outpacing the growth in household incomes. • Loans to investors currently account for close to 50 per cent of new housing loan approvals. • Investor activity has been particularly concentrated in New South Wales and Victoria. In New South Wales investor loan approvals have increased by about 90 per cent over the past two years. BIS central bankers’ speeches It is against this background that the Bank said in its Financial Stability Review last week that the composition of housing and mortgage market activity is becoming unbalanced. The review also indicated that we are discussing with APRA steps that might be taken to reinforce sound lending practices, particularly for investor finance, though not necessarily limited to that. I want to emphasise that the banks in Australia are resilient, and mortgage lending in this country has historically been relatively safe. APRA has, however, noted a trend to riskier lending practices, and over the past couple of years has been seeking to temper these through its supervisory activities. There are also broader concerns with the macroeconomic risks associated with excessive speculative activity, since this activity can amplify the property price cycle and increase risks to households. Our discussions with APRA and other agencies on these matters are ongoing, and there will be more to say about them in due course. For now, my colleague and I will be happy to take any questions that you might have. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 10 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to Citi's 6th Annual Australian and New Zealand Investment Conference, Sydney, 14 October 2014. | Guy Debelle: Volatility and market pricing Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to Citi’s 6th Annual Australian and New Zealand Investment Conference, Sydney, 14 October 2014. * * * Accompanying graphs can be found at the end of the speech. Thanks to Michelle Wright for her help. Today, I will talk about a few issues around pricing in financial markets and volatility, or more precisely, the lack of volatility. Volatility Financial markets have been quiet, maybe too quiet, for much of this year. Of course, in saying this it increases the likelihood of it ending sooner rather than later! Indeed, since drafting this speech, the VIX has risen to its highest level since February. If I had told you that there were heightened tensions in the Middle East and Eastern Europe, uncertainty about the turning point in US monetary policy, a succession of strong US job numbers, uncertainty about the future direction of policy in Europe and Japan, as well as increased concern about the strength of the Chinese economy, you would not be expecting that to make for a benign time in financial markets. But that is what we have seen for much of this year. The graph shows measures of volatility in fixed income, equity and foreign exchange markets. At some point this year, all of these have fallen to historically low levels. There has been little reaction to any of the events I have described. To the extent there has been any, it has been very short-lived. (Graph 1) In the past few weeks, volatility has picked up, predominantly in foreign exchange markets, which I will come back to a bit later. But even so it has not yet returned to a ‘normal’ level of volatility. So volatility has been low for a prolonged period of time in the face of a number of events which individually would normally be associated with high volatility, let alone all of them happening at the same time. Why is this happening? A number of explanations have been advanced, but I don’t find any of them particularly compelling, mostly constituting, at best, only ex post rationalisations. Macroeconomic outcomes for the world in aggregate have been relatively stable and that may be part of the story. World growth has been running at around 3½ per cent for the past couple of years and the latest forecasts have it continuing at that pace for the next year or so. But the relatively stable aggregate outcome masks quite a lot of variation across countries. A good example is the high volatility in growth in the first two quarters of this year in the US and Japan, the former resulting from weather, the latter from the consumption tax increase. Nevertheless, the relative stability of macroeconomic outcomes might be delivering a little more stability in the numerator in investors’ calculation of expected future returns. But it is not clear to me why there should be more stability in the denominator, the discount rate. If anything I would argue the converse, namely there is at least as much uncertainty about the future path of interest rates as in earlier periods. One popular argument for stability is that the low volatility reflects the forward guidance of central banks. This has purportedly reduced uncertainty about the outlook for policy. Two-way volatility in interest rates has naturally been restricted as rates have moved towards the zero lower bound, but much of this effect has been present for some years now. BIS central bankers’ speeches Moreover, with the zero bound being reached, policy uncertainty should translate to uncertainty about the use of other non-conventional tools to ease monetary policy. That is certainly true in Japan in recent years and more recently has been the case in Europe. But more importantly in my view, while there is more forward guidance from central banks in place than in the past, investors don’t have to believe it! Indeed, there are plenty of examples in history where that has been the case. I find it somewhat surprising that the market (in aggregate at least) is willing to accept the central banks at their word and not think so much for themselves. Moreover, as has been articulated any number of times, the guidance is clearly data dependent. If the data moves unexpectedly, in all likelihood so will the central bank. Markets appear to be underestimating that possibility. One thing which is certain is that the low volatility will not persist. What will cause it to end? I really don’t know, as any of the events I mentioned earlier could have been a trigger for more volatility, but clearly they weren’t. One interesting market development is how cheaply volatility protection has been sold over recent months. There has been an increase in supply as more institutions who have not been traditional sellers of protection enter this market seeking returns as part of a search for yield. While that may have dampened volatility of late, it does mean that losses will be incurred if volatility rises before the insurance expires. These non-traditional players may pull back from the market in such circumstances, exacerbating any rise in volatility when it finally eventuates. Market liquidity One other factor which market participants are concerned about is the prospect that when a sell-off comes, the volatility and price movements will be exacerbated by the reduced capacity and inventory of market makers. That is, market liquidity is structurally lower now than it was in the past. The lower liquidity is not evident in a rising market when assets are being bought, but will quickly become apparent in a down market as investors try to exit their positions. It is true that there is not as much market-making capacity as prior to the crisis. There are various metrics that demonstrate this and there have been some well-publicised exits by various institutions from different markets. Regulatory changes have, as intended, increased the cost of market-making, and hence shifted some liquidity risk to end investors. There have also been some strategic decisions taken by institutions and internal constraints have been imposed which have reduced capacity. The latter may have had at least as large an effect in reducing capacity as that of regulation. But it should be noted that the pre-crisis level of market liquidity was one where there was over-capacity, and hence not the benchmark to be regained. The question today is whether there is too little capacity. Unfortunately, we won’t really ever know the answer to this question. When volatility returns, for a number of reasons, including those I have already mentioned, it may well rise quite rapidly. One thing I am sure of is that the spike in volatility will be blamed, rightly or wrongly, on regulation-induced reductions in market-making. But if we look back at previous market sell-offs, when market-making capacity was larger, we see that they were often quite violent too. Market-makers can pull back in an environment of rapidly falling prices, either directly, or indirectly by significantly widening bid-offer spreads. Market makers generally have just as much reluctance to catch a falling knife as any other market participant. They are after all intermediators of risk, looking to lay it off quickly, rather than being a warehouser of risk. BIS central bankers’ speeches The bond market sell-off in 1994 is a good example. (By the by, I recall ‘94 quite well. At the time, I was the teaching assistant for Stan Fischer in the graduate macro course at MIT. He and I might be revisiting those events again soon in somewhat different occupations to our more sedate academic lives then.) There are a few other reasons to suspect that the sell-off, particularly in fixed income, could be relatively violent when it comes. First, there are a number of investors buying assets on the presumption of a level of liquidity which is not there. As I said earlier, this is not evident when positions are being put on, but will become readily apparent when investors attempt to exit their positions. If you are a buyand-hold investor focussing on the return on your investment, then secondary market liquidity is not really an issue (though it might affect your mark-to-market valuations on the way through). But there are probably a sizeable number of investors who are presuming they can exit their positions ahead of any sell-off. History tells us that this is generally not a successful strategy. The exits tend to get jammed unexpectedly and rapidly. On top of that, my time in financial markets has taught me that one should never underestimate the role of mechanical rules or mandates in driving market behaviour more than rational pricing. So there is a fair chance that volatility will feed on itself. One should always be careful of looking for too much rationality in trying to understand market dynamics. Given the lack of rational arguments for the current state of affairs, trying to rationally explain how it will unwind is also going to be difficult. Another reason to suspect that the sell-off might be violent is the starting point, namely zero nominal interest rates. That is a point we haven’t started from before (with the possible exception of Japan). There are undoubtedly positions out there which are dependent on (close to) zero funding costs. When funding costs are no longer zero, those positions will blow up. Where are they? How large are they? I don’t really have a good answer to those questions. It appears more likely that they are held by real money investors than directly on the balance sheets of the core banking system, which is probably a good thing. But then if we think back to 2007, structured investment vehicles weren’t directly on the balance sheet of the core banking system either. Related to the issues above, looking at pricing in fixed income markets globally, and most easily in US Treasuries, there is little in the way of term premia (that is, return for holding duration). There also appears to be very little uncertainty priced in about the movement in short term interest rates. At the end of last year, the term premia had started to rise, separate from any increased uncertainty about short rates, This separation was a good thing. But those premia have now fallen right back. My concern is that both of these will rise in concert, exacerbating the disruptiveness of the sell-off. In thinking about the magnitude and nature of any sell off, an important question to think about is who will take the other side of the trade? How far do prices need to go before someone is willing to take the position? Those questions are always relevant but the answers may be different this time around. I will now turn to look at some pricing developments in the foreign exchange market where as I mentioned earlier, there has been some return to more normal levels of volatility in recent weeks. FX The main development in foreign exchange markets in recent months is that the US dollar has appreciated. This has been a long-awaited event by many market participants, including ourselves. A sizeable number of macro funds had lost a fair amount of money over the past BIS central bankers’ speeches year waiting for this event to happen.1 Why the US dollar stayed at its low levels for as long as it did, and why it finally started to appreciate when it did, has baffled many in the market. As Keynes famously said, ‘the market can stay irrational longer than you can stay solvent’. A few well-known hedge funds came close to proving that proposition over the course of this year. The appreciation of the US dollar was not associated with any noticeable change in interest rate expectations in the US, and, in the case of the AUD/USD exchange rate, there was no material change in Australian interest rate expectations either. While the US dollar has appreciated, on a trade-weighted basis it is still not that far above its all-time lows reached in 2011. It has only appreciated by 4 per cent in the past few months, which is a small move in the history of swings in foreign exchange rates, where movements of up to 40 per cent have occurred. Similarly, while the euro has depreciated in recent months, on a trade-weighted basis the euro is not particularly low. (Graph 2) More generally, we are in an unusual environment where monetary policy settings in the four major economic regions – the US, China, Europe and Japan – are moving in divergent directions. It is an extreme environment that both markets and policy makers are operating in, where the balance sheets of major central banks are at an unprecedented size. It is challenging for foreign exchange markets and it creates a complicated environment for setting monetary policy in other parts of the world, including here in Australia. The appreciation of the US dollar in recent months has received a fair amount of attention. What has attracted less attention is that over the same time, the renminbi has moved in lock step with the US dollar, so that it too has undergone a sizeable appreciation. Over the past year, the RMB has appreciated by 5 per cent on a trade-weighted basis, while over the past 3 years it has appreciated by 13 per cent. (Graph 3) One noteworthy development over the past few months in foreign exchange markets is that volatility in emerging market currencies has generally been fairly contained while the US dollar has appreciated, certainly in comparison to the experience in the middle of 2013. (Graph 4) Turning to the Australian dollar, over the month of September the Australian dollar recorded one of the larger depreciations against the USD dollar, at around 6 per cent. Given that, and the fact the RMB continued to move in line with the US dollar and has the largest weight in the Australian dollar trade-weighted index (25 per cent), that translated into a trade-weighted depreciation of the Australian dollar of 4 per cent over the month of September. While that depreciation will do something to foster more balanced growth in the Australian economy, it has only served to take the trade-weighted index back to its levels of earlier in the year. (Graph 5) In part that is because the depreciation of the Australian dollar in September only saw it partly catch up to the depreciations which other currencies had experienced in previous months. So for instance, the Australian dollar is still 6 per cent higher against the euro since the beginning of the year. Why the Australian dollar held up for longer than other currencies prior to September is not clear. (Graph 6) Again, the Australian dollar has depreciated in recent weeks, but on a trade-weighted basis is only back to levels of earlier in the year. Over that same period, Australia’s terms of trade has continued to decline and some key commodity prices for Australia, most notably the iron ore price, have declined considerably. On that basis, the Australian dollar is still higher than most conventional estimates of fundamentals would indicate, notwithstanding its recent decline. The exchange rate is thus offering less assistance than would normally be expected Though obviously someone must have been on the right side of the trade. BIS central bankers’ speeches in achieving balanced growth in the Australian economy. A lower exchange rate would be helpful in achieving that objective. So in conclusion, there are a number of anomalies present in financial markets in terms of pricing and volatility. There are also some misplaced perceptions amongst market participants about the degree of liquidity present in some market segments. That strikes me as a dangerous combination and unlikely to be resolved smoothly. BIS central bankers’ speeches Graph 1 BIS central bankers’ speeches Graph 2 BIS central bankers’ speeches Graph 3 BIS central bankers’ speeches Graph 4 BIS central bankers’ speeches Graph 5 BIS central bankers’ speeches Graph 6 BIS central bankers’ speeches | reserve bank of australia | 2,014 | 10 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Leading Age Services Australia (LASA) National Congress, Adelaide, 20 October 2014. | Christopher Kent: Ageing and Australia’s economic outlook Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Leading Age Services Australia (LASA) National Congress, Adelaide, 20 October 2014. * * * I thank Tim Atkin, Laura Berger-Thomson, David Jacobs, Sharon Lai and Melissa Watson for help in preparing these remarks. Near-term outlook I’d like to thank Leading Age Services Australia for the opportunity to be here today. I want to focus on some implications of population ageing for the longer-term outlook. Before that, I’ll make two remarks about the near-term outlook. First, with inflation expected to remain consistent with the 2–3 per cent medium-term target, monetary policy is currently configured to support growth in demand. Low interest rates temporarily raise the disposable incomes of those with debt, but lower incomes for those reliant on interest-bearing assets. This is stimulatory nonetheless, in part because the household sector is a net debtor overall. Low interest rates also encourage expenditure to be brought forward, provide an incentive for savers to shift into riskier, higher-return assets, and push up asset prices, to the benefit of those that own housing and equities. A second point is that while monetary policy tends to focus on the outlook for the next few years – which is dominated by business cycle considerations – it is important for the Bank to account for longer-term structural changes. For example, labour force participation has declined noticeably over recent years. Much of this owes to the usual response of discouraged workers, both young and old, to subdued labour market conditions. 2 This discouraged worker effect is likely to unwind as conditions improve. But some of the decline also reflects the increasing effect of ageing on labour force participation. This illustrates the point that to understand the near-term outlook better, we need to distinguish between shorter-term business cycle influences and longer-term structural forces. An increasingly important longer-term force is the ageing of the population, which is the focus of the rest of my presentation. Population ageing – its nature Population ageing is driven by three different forces. The first is the baby boom that followed the Second World War. The second is the drop in fertility rates thereafter. Combined, these two changes led to a “bulge” in the age distribution of the population (Graph 1). The early part of this cohort began to retire from around the turn of the century and the baby boom is HILDA: The following Disclaimer applies to data obtained from the HILDA Survey. The Household, Income and Labour Dynamics in Australia (HILDA) Survey was initiated and is funded by the Australian Government Department of Social Services (DSS), and is managed by the Melbourne Institute of Applied Economic and Social Research (Melbourne Institute). The findings and views based on these data should not be attributed to either DSS or the Melbourne Institute. See Kent, C (2014), Cyclical and Structural Changes in the Labour Market, Address on Labour Market Developments, hosted by The Wall Street Journal, Sydney, 16 June. BIS central bankers’ speeches increasingly putting downward pressure on the share of the population that is of (traditional) working age. 3 Graph 1 The third force driving population ageing is rising longevity. Australians born today can expect to live nearly 25 years longer than those born a hundred years ago. The increase in life expectancy has occurred throughout this period and appears to be ongoing. Population ageing – some challenges Conversations about ageing often focus on the challenges it poses. But it also provides us with numerous opportunities. Let’s first consider some of the challenges and assume for the moment that behaviours don’t respond to population ageing. 4 (Relatively) fewer workers If people were to retire at about the same age as in the past, population ageing would drive further falls in labour force participation rates over coming years. By itself, ageing is estimated to have subtracted from the labour force participation rate by between 0.1 and 0.2 percentage points per year over the past decade and a half; this effect has picked up a little in recent years as baby boomers have begun to reach the age of 65 years. See Kent (2014) for details. These challenges, and possible responses to them, have been highlighted by the regular “Intergenerational Reports” since 2002, and by the Productivity Commission; see, for example, Productivity Commission (2013), “An Ageing Australia: Preparing for the Future”, Research Paper, November, available at: <http://pc.gov.au/__data/assets/pdf_file/0005/129749/ageing-australia.pdf>. BIS central bankers’ speeches The resulting decline in the supply of labour (relative to the total population) would tend to put upward pressure on wages (at least pre-tax wages) and reduce the returns to capital. 5 The pressures on the labour supply will be felt more acutely by industries that rely more heavily on labour. Most notably, this includes services industries, such as aged care and health care (Graph 2). There is, however, likely to be scope for labour to be reallocated across services industries. In particular, an older population will require relatively fewer workers to care for and educate children. Graph 2 More demand for services At the same time as labour will tend to be in shorter supply, larger shares of the population will need a degree of assistance and care. Indeed, demand can be expected to shift towards services (away from goods) given that services constitute a larger share of total consumption for older people than for the rest of the population (Graph 3). 6 Much of this reflects spending on health care. This extra demand for services will be in addition to that associated with rising wealth. People tend to spend an increasing share of their rising incomes on services in part because there are ultimately limits to the consumption of food, wearing of clothes and use of other goods. This discussion ignores the role of international capital mobility, but given that population ageing is a global phenomenon, the qualitative results of closed and open economy models will be comparable. To gauge the true extent of this we need to account for goods and services that people purchase for themselves directly, as well as those they obtain through the public provision of goods and services, which is what Graph 3 has done. BIS central bankers’ speeches Graph 3 So, we can expect that ageing will lead to extra demand for services at the same time that it weighs on the supply of services (via declining labour force participation). More demand and less supply will push up the prices of services, relative to the prices of goods. This rise in the relative price of services has long been apparent for other reasons. One reason for this is that productivity growth has tended to be greater for goods than for services. That is, we’ve got better at producing more goods for a given level of inputs, more so than has been the case for services. Another reason is that the global integration of much of Asia over recent decades has brought large numbers of workers into the production of traded goods, increasing their supply and therefore pushing down the relative prices of goods. It is important for stronger wage growth, and an increase in the relative prices of services to occur. Such signals will encourage higher labour force participation than would otherwise be the case and bring forth the additional supply of services that we will want and need. Pressures on the public purse Population ageing will place the public purse under a degree of pressure in a number of ways. Public revenues will face downward pressure given the declining share of the population paying income taxes. 7 Public expenditure will tend to rise given the demands on public pensions and the fact that many of the types of services that older people require are provided by the public sector directly. Insufficient savings to fund retirement? We are becoming wealthier and, through compulsory superannuation and other means of saving, we have gradually been building up private savings to fund retirement. But if we retire This relies on two reasonable assumptions. First, the fall in the labour-to-capital ratio is not completely offset in nominal terms by the increase in relative prices (wages vs returns to capital). Second, labour income is taxed at a higher rate than capital income. BIS central bankers’ speeches at much the same age as earlier generations had been used to, with longer lifespans on average we’ll have to fund quite lengthy periods of retirement. Moreover, this will be an environment where there will already be considerable pressure on the public purse, for the reasons I have just noted. Insufficient risk-taking and innovation? One last challenge I want to raise relates to productivity growth. There is evidence that older people tend to be less willing to take on risks, including those associated with new business ventures, developing new products and services, and pursuing innovation more generally (Graph 4). 8 For this reason, it is possible that ageing could weigh on productivity growth, and hence on our incomes and economic wellbeing. 9 Graph 4 Population ageing – opportunities to meet the challenges Focusing only on the challenges would leave us with a rather gloomy picture of ageing. Fortunately, individuals and economies tend to be responsive to these sorts of challenges. Allowing relative prices to change and enabling individuals and businesses to alter their behaviours in response to those price signals is a critical part of the adjustment process. Applying a little foresight will also be helpful. And the key point I would like to emphasise is that rising longevity provides us with a number of opportunities to meet these challenges. Older people are more likely to own an unincorporated business, although this may merely reflect the operation of credit constraints, which would be likely to make it more difficult for younger people to start a business. See Lowe P (2013), “Demographics, Productivity and Innovation”, Speech to The Sydney Institute, Sydney, 12 March. BIS central bankers’ speeches Longer working lives Not only are we living longer, but life spans are also generally healthier than in the past. 10 Among other things, this provides the option of working productively later into life. Let me be clear though, extra years of work need not imply less years in retirement. (I’ll come back to this point in a minute). Also, many (though by no means all) jobs are less taxing on peoples’ bodies than in the past. This makes it easier to spend extra years of life in the work force, which is already happening to some extent. Many types of workers have been retiring a little bit later in life over recent years and participation rates among older people have been rising over a long period of time (Table 1 and Graph 5). 11, 12 Not surprisingly though, this change is not generally evident for those with very taxing jobs, such as labourers who tend to retire several years earlier than other workers. Greater opportunities for part-time work have helped to contribute to rising participation rates among older people. Changing social norms more generally – particularly for women – have also made a contribution to rising labour force participation. For a discussion of this point see Productivity Commission (2013), Kulish M, C Kent and K Smith (2010), “Aging, Retirement, and Savings: A General Equilibrium Analysis”, B.E. Journal of Macroeconomics, vol. 10, no. 1, and the references therein. The recent cyclical weakness in the demand for labour seems to have put paid to the trend rise in participation rates among older members of the population seen over recent decades. But the response to rising longevity (and other forces) might reassert itself when demand for labour strengthens. See Kent (2014). There is a possibility that the changes over time shown in Table 1 were driven in part by a temporary response to the decline in wealth associated with the global financial crisis. That is, people who might have otherwise retired decided to stay on at work, and for others to re-enter the workforce, to make up for declines to wealth following declines in housing and equity prices following the financial crisis. However, patterns across different workers over the intervening years (including data for 2008 and 2010, not shown), combined with the longerterm rise in participation of older ages in Graph 5 suggests that factors other than just the financial crisis have been responsible for later retirement. BIS central bankers’ speeches Graph 5 A rise in wages – which I have suggested is in prospect over the longer term – would provide an incentive for people to enter and remain in the workforce. Incentives related to the provision of public pensions and the treatment of superannuation will also have a significant bearing on the labour force participation of older people. Higher savings It’s possible that we will choose to use longer lifespans in such a way that, on average, we’ll work some extra years and spend more years in retirement. It’s possible that we’ll increase the share of our lives in retirement. Indeed, that would make sense because as we become wealthier over time, we can enjoy the better things in life, including more leisure. In any case, we’ll probably want and need more savings to fund additional years spent in retirement. 13 One way to do this is to save more during each year that we work. The power of compounding returns means that this strategy would be particularly effective if we do so earlier on in our working lives. Working for longer is another option. Individuals can add to their own savings during extra years of work, and delay the time at which they start to drawdown private savings. Also, this allows them to make further contributions to public revenue (via income taxes) and delays any need they may have to draw on the public purse. If we manage to build up savings in preparation for ageing – as I’ve suggested we should – ultimately this can be used to fund investment. That is, more savings will support a rise in the stock of an economy’s productive capital. Even if that extra capital is not put to work Some modelling work I did with colleagues at the Bank a few years ago showed that, under plausible assumptions, an optimal response to ageing would see a rise in savings and a rise in the ratio of capital to labour; see Kulish M, C Kent and K Smith (2010) for details. More savings allow the capital stock to rise at the same time as the share of population working declines. People work more years of their lives, in part to help them build up their savings. Nevertheless, they need not spend a greater share of their lives working. An additional reason to work for longer and save more is that the rise in the capital stock relative to labour implies a lower return to capital and higher wages paid to labour. BIS central bankers’ speeches providing additional services, it can still be used productively in more capital intensive industries. This would free up some labour to work in the services sector. 14 Education Longer life spans provide opportunities and incentives to gain more education or learn a trade, and to do so later into life. This result is relatively straight forward. Education and training, particularly beyond high school, are costly for the individual, in part because of the opportunity cost of foregone income. A longer working life raises the life-time returns to advanced education and training, thereby providing the incentive to do more of it. Although other factors may be at work here, there is evidence that more people have been obtaining qualifications beyond high school over the past couple of decades (Table 2). 15 Raising our human capital should help to make our economy more productive. Risk taking As I have already discussed, a rise in the share of older people might reduce the extent of risk-taking and innovative behaviour in an economy. But that is not where this story ends. It is important to recognise that a decline in the share of people taking risks would raise the return to risk taking. A response of others to this incentive would help, in part, to offset the initial impetus to reduced risk-taking flowing from population ageing. It is also possible that longer life spans may make people more willing to take on risks at any given age. Why? Take the example of someone considering a new business venture. They might be more willing to do so knowing that they would have more productive years to take advantage of a successful business. Moreover, in the event of failure, they still have many productive years ahead to generate a decent income doing something else. 16 They could use those years to pursue a safer option to generate a living, or even take on a different risky venture. In short, “40 may be the new 30” when it comes to comparing the willingness of the current generation to take on risk compared with those born only a few decades ago. For example, consider the case of an agrarian island economy facing the prospect of ageing. It would make sense for savings to rise allowing for the purchase of more farm equipment – say a tractor. This would enable some younger workers to be freed up from food production to work instead providing care for the aged. Alternatively, some of those savings can be put to work offshore, with the income from that covering the cost of imported food and other goods, also allowing resident workers to shift into the provision of services. Other factors include changes in education policies and relatively higher returns to further education and training driven by the changing nature of jobs. The global integration of large economies with plentiful supplies of lower-skilled workers, such as China, is also likely to have played a role in lowering the relative returns to less-skilled labour. The same logic might lead to an increased willingness to borrow more and maintain debt later into life than was the norm for earlier, shorter-lived generations. BIS central bankers’ speeches A role for immigration? Is there room to counteract, or at least mitigate population ageing pressures through immigration? At the margin there is, since the median age of new immigrants is around 25 years, which is currently about 10 years less than the median age of the average Australian. But this effect is already in operation given the significant contribution to Australia’s population growth from immigration over recent years. Also, with populations ageing globally, immigration cannot be a panacea for all economies. Conclusions In summary, ageing of the population will have an increasingly important bearing on various aspects of the economic outlook. Among other things, it will tend to weigh on growth of economic activity, labour force participation and the public purse. It may weigh on productivity growth to the extent that it leads to less risk-taking and innovation. It will also lead to a rise in the demand for a range of services, including aged care. The economy will be best placed to handle these significant changes in factor and product markets if we are responsive to the resulting changes in relative prices and returns to factors of production. We’ll be even better placed if we can act with a degree of foresight. What sort of responses might we expect? It will make sense for a combination of extra savings to be built up and for us to do what we can to raise participation rates, including by having people work later into their lives. Extra capital from the rise in savings can be channelled into both goods and services, though it is likely that productive resources (labour and capital) will be required to shift towards the services sectors. While the challenges are relatively obvious, one aspect of ageing presents us with valuable opportunities. Rising longevity will provide us with the ability and willingness to work later into life, without necessarily implying a change in the share of our lifetimes we spend in retirement. This will allow us to bolster participation, savings and reduce the burden on the public purse. Recognising that on average we’ll enjoy longer lives, may also encourage a rise in education and training. We may also become more willing to pursue risky, innovative business opportunities at any given age compared with what had been the norm for earlier generations. Public policies have an obvious role to play, facilitating these adjustments where possible. The Reserve Bank can best contribute to the necessary adjustments to population ageing by maintaining low and stable inflation. This does two things. First, it encourages investors and businesses to focus on generating real returns rather than trying to avoid the effects of high inflation. Second, it enables changes in relative prices and relative returns to factors of production to be observed more clearly than in a world where inflation is high and variable. And it is these price signals that will facilitate the necessary adjustments in behaviour. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 10 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Commonwealth Bank of Australia's 7th Annual Australasian Fixed Income Conference, Sydney, 21 October 2014. | Philip Lowe: Investing in a low interest rate world Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Commonwealth Bank of Australia’s 7th Annual Australasian Fixed Income Conference, Sydney, 21 October 2014. * * * Thank you very much for the invitation to speak tonight at the Commonwealth Bank’s 7th Annual Australasian Conference. I would like to extend a particularly warm welcome to those of you who are visiting Australia to gain first-hand knowledge of our economy and our financial markets. Welcome to our shores. The general topic that I would like to speak about this evening is investing in a low interest rate world. No doubt this is an issue that you have all pondered over recent times. No doubt you have all thought about which assets offer the most attractive returns in the post-crisis world in which interest rates in many countries are extraordinary low. And no doubt you have thought about the risks that come with those assets. I am not a financial advisor, so I will refrain from giving you advice on how to grapple with these difficult issues. But I would like to talk about a couple of the general challenges that we face in this world of low interest rates. The first issue has an international dimension and it has been the focus of many of the discussions around the G20 table this year – and that is, how do we translate greater risktaking on the financial side of the economy into greater risk-taking on the real side. The second issue, which has a more domestic focus, is recent developments in the Australian housing market. The international challenge It is useful to start with a reminder of just how unusual the current global environment is. Interest rates are as low as they have ever been in most advanced economies. In the United States, the euro area, Japan and the United Kingdom official interest rates are essentially zero. In Germany, investors actually pay the government for the privilege of lending to it for terms of three years or so. And in the euro area, banks are now faced with negative interest rates on their deposits at the European Central Bank (ECB), and the ECB is prepared to lend money to banks for terms of up to four years at just 15 basis points. A number of the major central banks have also engaged in very substantial money creation to buy large quantities of assets from the private sector, including government bonds, assetbacked securities and equities. As a result, financial institutions are holding record balances at central banks and central banks have become very large managers of assets themselves. While it is easy to lose track of time, global monetary affairs have been in this very unusual territory for quite some time. It is now six years since the financial crisis was at its peak. Even with the knowledge that the recovery from financial crises can be frustratingly slow, few observers predicted that the crisis would throw such a long and enduring shadow over monetary and financial conditions in so many countries. This shadow has created a difficult environment for savers and those managing savings. Perhaps at the risk of over-simplifying things, they have three basic choices: 1. They can leave the savings in the bank and earn zero (or less). 2. They can use the savings to purchase existing assets from other investors in the hope of earning a positive return. BIS central bankers’ speeches 3. They can use the savings to finance the development and creation of new assets, for example a new piece of capital equipment, a new building or some new intellectual property. It is this third use of savings that is critical to the resumption of strong growth in the global economy. When the crisis hit in 2008, the first of these three savings choices dominated. Investors were intent on preserving their capital and remaining as liquid as possible. Many sold their more risky existing assets and the prices of these assets declined, in some cases significantly. There was an even more precipitous decline in the demand for new assets, with aggregate investment in many countries dropping to very low levels as a share of GDP. As we gradually climbed out of the crisis, attitudes to investing evolved. Faced with very low interest rates on safe assets and evidence that the global economy has been on a recovery track of sorts, investors have been prepared to move out along the risk spectrum and purchase existing assets as they search for yield. In response, the prices of these assets have risen again. This rise in the prices of existing assets is understandable. Indeed, it is one of the channels through which stimulatory monetary policy works. Low interest rates make it less attractive to hold savings in bank deposits and more attractive to hold other existing assets – and prices respond. The higher asset prices should then both encourage, and make it easier for, firms to increase their investment spending – that is, to use their savings to finance the creation of new assets. It is this latter part of the transmission channel that is proving frustratingly slow in many countries. The strong demand for many existing assets has not yet generated a strong appetite for the creation of new assets. Many investors remain very cautious when considering funding business expansion and aggregate investment remains low. In response, central banks have felt that they have had no choice but to continue with very expansionary policies and, in some cases, to add yet further stimulus. The hope is that in so doing they will eventually induce a shift from the world of strong demand for existing assets to one in which there is strong demand for the new assets that will create the growth and jobs that are so badly needed. This slow transition has been one of the central issues that we have discussed around the G20 table over the past year under Australia’s presidency. A key question we have been asking ourselves is what can be done to speed up this transition. One perspective is that it is just a matter of time. It takes time for demand to recover, for excess capacity to be wound back and for business confidence to return. Time also leads to the depreciation of the existing capital stock. So, maybe we just need to wait a bit longer. In the United States, we are, perhaps, getting close to the point where things will turn. But in Europe and Japan, it is difficult to have the same degree of optimism. The obvious problem with waiting is that it can be very costly in terms of jobs and overall economic growth. It can also generate new risks. In particular, the prolonged highly stimulatory monetary policy that is required during the waiting period can lead to the development of new financial vulnerabilities. Indeed, this appears to be occurring at the moment. The search for yield, the low volatility, the elevated prices of some assets, the compressed credit spreads and the pockets of higher leverage that we have witnessed recently has made the system more vulnerable to unexpected events. So what can be done to promote healthy growth and reduce financial risk? The G20 discussions have highlighted two broad lines of attack. The first is the promotion of structural policies that encourage real investment, not just financial investment. This is, of course, easier to say than to do. But policies that promote trade and competition, and that promote innovation and entrepreneurship, must surely be at BIS central bankers’ speeches the heart of the solution. Globally, policymakers need once again to create an environment where savers feel that it is worth taking a risk developing a new asset. Higher prices for existing assets can help in this regard, but only so far. It is reform-focused government policy, rather than monetary policy, that is the key. The second response is increased spending on infrastructure, which creates new assets directly. From a number of perspectives now is a favourable time to undertake such investment. In many countries, the infrastructure is ageing and/or underdeveloped and there is a growing likelihood that this will inhibit future economic growth. The record low interest rates and limited recent investment mean that there are likely to be many projects that yield riskadjusted social rates of return greater than the cost of finance. There is also plenty of spare capacity to undertake such investment. In addition, higher levels of infrastructure spending could take some of the pressure off monetary policy globally, ultimately reducing some of the risk in the financial system that I referred to a moment ago. So, there is much to commend it. One of the main stumbling blocks continues to be financing. Typically, building infrastructure requires somebody to borrow. At the moment, few entities want to do this. Many private investors remain wary of borrowing given the construction and patronage risks often associated with infrastructure investments. In earlier eras, governments might have been prepared to step in and use their own balance sheets to boost demand. But today, many governments remain very wary of doing this, given the need to put public finances on a more sustainable footing. The end result is that investment in infrastructure remains low despite record low interest rates, a deficiency of global aggregate demand and infrastructure shortfalls in many countries. This is hardly an ideal situation. As the G20 has identified, finding solutions here is important to the health of the global economy. In Australia, the federal government’s asset recycling program is one way of increasing infrastructure investment without increasing government net debt. More generally, better balance sheet accounting by the public sector would also be helpful. Borrowing to build assets can be thought of quite differently from borrowing to finance current expenditure provided – and this is important – that one can have a degree of confidence that the asset will deliver a reasonable return. So, more rigorous processes around project selection and governance are important. The G20 has also been working on ways of improving contracting and the private-sector financing of infrastructure investment, including through appropriate pricing, as well as sharing experiences across countries. Both of these elements – the promotion of real risk-taking and increased spending on infrastructure – are central in delivering on the G20 commitment to lift global GDP by an additional 2 per cent by 2018. They are both important in creating a stronger global economy where investors look for new opportunities rather than simply seeking out existing assets. Progress has been made on delivering on this commitment, although more is needed and effective implementation is clearly required. Australian developments I would now like to turn my focus more directly to domestic issues. For reasons that I expect you already understand, Australia has found itself in a different position from that of many other advanced economies over recent years. Our banking system came through the international crisis quite well. Aggregate investment has been high, not low. Interest rates are positive, and the Reserve Bank has not had to buy large quantities of assets from the private sector. But we do live in an interconnected world. So what is happening elsewhere does have an effect here. While our interest rates are positive, they are at record lows. While aggregate investment has been very high, investment outside the boom in the resources sector has been very subdued. And as we have seen elsewhere around the world, many companies BIS central bankers’ speeches have preferred to hold cash or distribute profits back to their shareholders rather than invest themselves. So we face some of the same issues as other countries. This means that the discussion about the promotion of entrepreneurship and increased spending on infrastructure is not just relevant to the global economy, but to Australia too. Over the period ahead, higher infrastructure spending can help with the transition from the mining investment boom to other forms of activity. It can also help strengthen the foundations for future growth in the economy. And, as I have spoken about on previous occasions, policies that promote innovation and entrepreneurship are likely to hold us in good stead not just in the short term, but over the long term as well. In terms of the financial side, it is in the housing market where the strong demand for existing assets is most evident. Many investors, including those in self-managed superannuation funds, have decided that investment in residential property is an attractive option, partly given the low level of interest rates. Prices have risen as a result. Nationwide, they are up by around 10 per cent over the past year, and in Sydney they are up by around 13 per cent. Auction clearance rates have been high and loan approvals for the purchase of residential property have risen very strongly. The good news is that this increased demand for existing housing assets is translating into increased demand for new housing construction. This is a very welcome development. Investment in residential construction has increased by 9 per cent over the past year and further increases are expected. So this part of the monetary transmission mechanism is working in Australia, and working more effectively than it is in some other countries. The higher construction activity is adding to jobs and assisting with the rebalancing of demand in the economy as mining investment declines. But recent developments do raise some of the same general questions that are being discussed internationally. In particular, a question that has a strong echo in the international discussions is whether the recent increases in the prices of the existing housing stock, together with pockets of higher borrowing, is generating increased financial and macroeconomic risk? And if it is, what, if anything, should be done? Questions about how risk is evolving are often difficult to answer and one can never be completely confident that the conclusion reached is exactly right. But, it is possible to make informed judgements based on the balance of probabilities. And, the judgment that we have reached over recent times is that at least some aspects of the housing market have become somewhat unbalanced and that this has generated some increase in overall risk. The area that has attracted most attention is the very strong demand by investors to buy housing for the purposes of renting. Currently, loan approvals to investors buying properties to rent out account for nearly 45 per cent of total loan approvals, with most of the investment properties being existing properties. Perhaps not surprisingly, the biggest increases in housing prices have occurred in the city where investor demand has been strongest – namely Sydney. Overall, investor credit outstanding is growing at an annual rate of close to 10 per cent, around twice the rate of increase in household income. A fairly high and increasing share of these investor loans do not require the repayment of any principal during the life of the loan. And this is all occurring in an environment in which growth in rents has slowed and the ratio of housing prices to income is at the top end of the range experienced over the past decade or so. Now as I said, one cannot draw conclusions with absolute confidence, but I contend that a reasonable interpretation of these events is that they are leading to some increase in overall risk. It is important to make clear that I am not saying that this will end badly, or even that is likely to end badly – just that, on average, recent loans are probably a bit more risky than those BIS central bankers’ speeches made earlier. One reason this might be the case is that the likelihood of some type of painful household balance adjustment in the event that there is a correction in the housing market, while still not high, has probably increased. Given this, it is prudent for both borrowers and lenders to be careful. Quite appropriately, the Australian Prudential Regulation Authority (APRA) has been discussing this evolution of risk with financial institutions for some time, and there has been a strong focus on maintaining appropriate lending and risk-management standards. As has been well publicised, the members of the Council of Financial Regulators, including the Bank and APRA, have also held discussions regarding the merits of additional measures within the existing prudential framework. If risk has increased, then it might be appropriate to adjust one or more of the elements within that framework to reflect that change in risk. It is also important to point out that the fact that the Bank and APRA are talking about these issues does not mean that a return to the type of heavy regulation we saw in earlier decades is on the agenda. That earlier experience demonstrated all too clearly the distorting effects of such regulation as well as the ability of financial institutions to circumvent it, including by activities outside the regulatory net. As it turns out, the financial system is very good at finding ways of getting money from the people who have it to those who want to borrow it, although perhaps less good at containing aggregate risk. All this means that we need to be realistic about what can be achieved through changes in the regulatory parameters alone. This realism, however, need not preclude consideration of modest and sensible changes within the existing prudential framework. Obviously, another relevant issue is the overall level of interest rates. As I have said, low rates have boosted asset prices globally, including in our own housing market. The judgement that the Reserve Bank Board has reached is that in Australia these low rates are entirely appropriate. They are required to assist in the necessary balancing of the Australian economy following the once-in-a-century boom in resources sector investment. This is especially so when the exchange rate has not been providing the degree of support that might normally have been expected. The low interest rates are helping boost construction activity and spending more broadly in the economy. This is the transmission mechanism at work. But just like the situation internationally, as the period of very low interest rates continues to run on, we all need to be cognisant of how risk is changing. Lenders need to ensure that their lending standards remain sound and that they hold the appropriate amount of capital against the risks they face. And investors need to evaluate developments in the broader market, including how their investments might turn out in less benign scenarios. Careful attention to these issues will help ensure that in getting the economic benefits of low interest rates we do not generate unacceptable risks on the financial side. Concluding remarks Let me conclude by trying to tie these various strands together. Very low global interest rates have been with us for some time. And it is likely that they will stay with us for some time yet. Fundamentally, this reflects the low appetite for real investment relative to the appetite for saving. These low rates are encouraging investors to buy existing assets as they seek alternatives to bank deposits earning very low or zero rates. Asset prices have increased in response. Some of this is, of course, desirable and, indeed, intended. But the longer it runs on without a pickup in the appetite for real investment, the greater is the potential for new risks to develop. During this period, while we wait for the investment environment to improve, we need to be BIS central bankers’ speeches cognisant of potential risks of asset prices running too far ahead of real activity. This is true in Australia, as it is elsewhere around the world. The underlying solution is for an improvement in the investment climate. Monetary policy can, and is, playing an important role here. But ultimately, monetary policy cannot drive the higher ongoing expected returns on capital that are required for sustained economic growth and for reasonable long-term returns to savers. It is instead government policy – including in some countries, increased spending on infrastructure – that has perhaps the more important role to play here. Thank you very much for listening this evening. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 10 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Annual General Meeting of the Australian Payments Clearing Association, Sydney, 23 October 2014. | Glenn Stevens: Issues in payments systems Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Annual General Meeting of the Australian Payments Clearing Association, Sydney, 23 October 2014. * * * Thank you for the invitation to speak on the occasion of Australian Payments Clearing Association’s (APCA) Annual General Meeting. The Reserve Bank and APCA have a long history of working constructively as they carry out their respective responsibilities in Australia’s payments system. We both have an interest in ensuring a safe, efficient and competitive payments system that meets the needs of end-users. When I last addressed an APCA gathering in May 2012, we were at a particularly interesting juncture for the payments industry. The Bank was approaching the end of a two-year period of public discussion and consultation about innovation in the payments system. This extensive public process, involving all the key industry players, and users of the payments system, had not been done before. After a roundtable attended by most members of the Payments System Board, numerous meetings at staff and management level, extensive feedback about published material and so on, the Bank released the conclusions of its Strategic Review of Innovation in the Payments System in June of that year. The Reserve Bank regards that document, and the process that led up to it, as a landmark for the payments system in Australia. Interestingly enough, the Innovation Review was not mainly motivated by concerns, on our part, that innovation was not occurring, even though it was sometimes claimed that the regulatory regime inhibited it. On the contrary, we were seeing, and continue to see, rapid innovation in some elements of the system, as financial institutions, payment schemes and a variety of other players seek to deploy new technology to compete with one another or to draw business away from traditional payment forms like cash and cheques. The most obvious recent example is the use of contactless payments. In mid 2012 relatively few of us would have made a contactless payment. Now they have become second nature to most of us and Australia has become the leading contactless market in the world. While this does not represent a fundamental change in underlying payment systems, it is a quite significant change in the way consumers interact with the payments system and changes the cost of payments to both merchants and consumers. Our recent diary survey suggests that the adoption of contactless has largely reflected a switch from traditional contact-based card presentment, but that there has also been some displacement of cash, particularly at smaller transaction sizes. 1 We are also now seeing the roll-out by several players of mobile-phone-based point-of-sale card acceptance facilities, where an intermediary provides a merchant some form of attachment to a smartphone or tablet, turning that phone or tablet into a card-acceptance device. This has significant potential to spread further the appeal of electronic payments to smaller businesses. At the same time, a clear trend towards online commerce and online banking is leading to a rapid increase in remote – as opposed to point-of-sale – payments. This is likely to be an area of increased competition, but is also the focus of increased efforts to improve the security of payments. Overlaid on all this is a proliferation of new models for using existing payment methods and indeed some proposals to change fundamentally the way we think about payments. Ossolinski C, T Lam and D Emery (2014), ‘The Changing Way We Pay: Trends in Consumer Payments’, RBA Research Discussion Paper, No 2014–05. BIS central bankers’ speeches The one area where there has been less progress than we might have expected in 2012 is “mobile wallets” for point-of-sale payments, i.e. where a consumer’s card or account information is incorporated into a phone application and the phone becomes the consumer’s payment device. Of course, this may well change quickly at some point. So innovation is proceeding. It would seem premature to expect that we have seen the apogee of technological development in the payments space. More likely it will continue, in ways that are impossible to predict, but are likely to be “disruptive” – the adjective of choice these days. But there is a key caveat here. Innovation in the payments system is not just a matter of technology – as remarkable as the extent of technological advance has been. We have had rapid innovation in areas where individual entities can innovate on their own, or where a central scheme has the capacity to push innovation out to its members and/or users. These innovations can provide significant benefits, but by themselves are not enough, in the Bank’s view, to deliver the policy goals set for the Payments System Board in its mandate. The setting within which innovation occurs also matters. The Innovation Review recognised that, in networks, where the ability of one institution to deliver value to its customer is dependent upon how well it can connect with all the other institutions and their customers, the full flowering of innovation depends to no small extent on system architecture, as well as governance. The technical architecture – for example, hub-and-spoke architecture versus bilateral links – can make it easier for new or established players to take advantage of technological change to bring new services to customers, or harder. Governance around processes can be accommodating to change or resistant to it. Overall, the record in Australia in instances where innovation requires cooperation between established players, especially where one or more of them feels the need to protect an existing line of business, is mixed. We are all aware of important cases where things have run into the sand. This isn’t just a problem for the industry. It’s a problem for the users of the system as well. Innovation in the “cooperative space” – where no single entity has control – is critical because it is this space that determines the limits on the services that the rest of the payments system can provide. These issues have been a matter of concern for the Payments System Board for quite a long time. The Board has always seen fostering innovation as part of its “efficiency” mandate under the Payment Systems (Regulation) Act 1998. An important speech by Philip Lowe as long ago as 2005 focused on payments system architecture (in particular the bilateral nature of a number of important payment systems), the limitations of governance arrangements and the challenges for the industry in making cooperative investment decisions. His overall observation was that the then-existing arrangements were hindering innovation. 2 Of course the technical architecture of systems is largely a legacy of decisions taken in an earlier era, probably for good reason at the time. Changing that architecture is difficult and costly, though that is not a reason not to try and certainly not a reason not to adopt better architecture for new systems. The establishment of EPAL, for example, has provided an opportunity to improve the network architecture of the eftpos system to allow it to better adapt to the demands of the modern economy. There have also been some important developments in industry governance. First, APCA itself has this year implemented some significant reforms to its governance. The new board structure includes representatives of the major banks, the mid-sized and foreign banks and Lowe P (2005), ‘Innovation and Governance of Payment Systems’, address to Banktech.05 Conference, Sydney, September. BIS central bankers’ speeches the credit unions and building societies. It also includes an independent chair and two other independent directors. New types of players are also represented at other levels within the APCA structure, better reflecting the make-up of the modern payments system. APCA’s willingness to make these changes is to be commended. Second, APCA and the Reserve Bank have also worked jointly towards the formation of a new body that is intended to take a higher-level, more strategic view of the payments system. This is a direct response to one of the important conclusions of the Innovation Review – that some of the difficulties that institutions faced in undertaking collaborative innovation might be alleviated by the creation of a body that would have senior-level representation from a wider range of organisations than have traditionally been members of APCA. The resulting body is the Australian Payments Council. The Council, which will have its first meeting next week, comprises 14 members, including from institutions typically represented on APCA’s Board, plus representatives of payment schemes, retailers with their own payments infrastructure and other payment services providers. The Council will have an independent chair and representatives from APCA and the Reserve Bank. The formation of the Council is a very important development. The Payments System Board expects it to take an industry-wide view as to how the payments system can better meet the needs of end-users. On that basis, the Board looks forward to active engagement with the Council. That in no way indicates that we see a lesser role for APCA. On the contrary, APCA’s role continues to be very important, including in some aspects of self-regulation and facilitating industry collaboration in determining rules and standards for the five different clearing streams that APCA oversees. APCA has also been active in thought leadership and advocacy for the payments industry. For example, APCA is currently playing a role in thinking about transitioning payments to the digital economy. It has published a series of “Milestones” reports – the most recent in July – looking at developments in the use of payments, and in particular the decline of cheques and the transition away from cheques and cash towards electronic payments. Not surprisingly, the reports highlight that use of electronic payments is continuing to grow strongly, while use of the traditional “paper-based” payments is falling. This, I might add, is consistent with the findings in the Bank’s recent consumer use survey. Our study – the third of its type – provides transaction-level data from a survey of over 1,000 consumers. It found that cash remained the most frequently used means of payment in 2013, though its use had declined noticeably over the previous three years. Cash accounted for 47 per cent of the number and 18 per cent of the value of all payments in 2013, down from 62 per cent and 29 per cent respectively in 2010. Cash was used particularly intensively for low-value transactions, with consumers using cash for around two-thirds of payments under $20. While the use of cash is declining relative to other payment mechanisms, it will continue to have a role in the economy. Indeed, as the Bank has noted previously, banknotes on issue have for a long period grown broadly in line with the nominal growth in the overall economy. And the consumer use survey suggests the amount of cash in respondents’ wallets grew between 2010 and 2013. Together, this evidence suggests that cash continues to have a significant role – not just for small-value transactions, but also both as a store of value and for precautionary use when other means of payment are not available. This is one of the reasons that the Reserve Bank is undertaking its Next Generation Banknote program, which will ensure that Australians can continue to have confidence in the nation’s banknotes as an effective means of payment and secure store of wealth. But this is not inconsistent with the Bank’s desire to encourage the efficient use of electronic payments. A more marked decline is evident in the use of cheques. The number of cheques written in Australia peaked around 1995. Since then, the number of cheques written each year per capita has fallen by more than 80 per cent (from 45 to 8). Over the same period, the number BIS central bankers’ speeches of electronic payments per capita has risen by more than 400 per cent. As the use of cheques has fallen, the per-cheque cost to financial institutions and businesses has generally risen. The market has, and continues to, respond to these pressures by looking for more efficient ways to process cheques, but they are clearly the highest cost payment instrument, as will be confirmed when the Bank releases its payments cost study later this year. This decline in the use of cheques, a very expensive payment instrument, is one that the private and public sector will have to manage. Part of that will involve the introduction of effective and readily available substitutes for users, and initiatives such as Superstream and eConveyancing are likely to be part of this. Central to the industry’s efforts to develop new payment products and services will be the New Payments Platform (NPP). I would like to use my remaining time to make some comments about this important project. A key point in the Innovation Review process was the industry roundtable held in 2012, focusing on the familiar themes of payments system gaps, governance and architecture. My recollection of the discussion was that there was fairly widespread acceptance that the industry would need to find a way to make some bold decisions about cooperative investments in payments system infrastructure not too far down the track. This has been echoed in subsequent views expressed by some of the key players. The Reserve Bank agreed. The Payments System Board has seen its own role as acting as a catalyst for that cooperative investment. In the Conclusions to the Innovation Review, the Board announced its intention periodically to set some strategic objectives or general goals in terms of the services that the payments system should be able to provide to end users. The five strategic objectives that the Board set in 2012, after lengthy consultation and with, I think it can be said, a wide consensus within the industry, were as follows: • all direct entry payments to be settled on a “same day” basis • the ability to make retail payments in real-time • the ability to make and receive payments outside of normal banking hours • the ability for payments to carry more complete remittance information • the ability for payments to be addressed in a simpler way than using a BSB and account number. The first of these, the same-day settlement of direct entry payments, was achieved in 2013. It is therefore now possible for recipient financial institutions to make funds available to their customers sooner, without incurring credit risk. The Bank worked closely with the industry to facilitate same-day settlement, including the introduction of new liquidity arrangements for exchange settlement accounts at the Reserve Bank. These new liquidity arrangements will also be important as the industry moves to meet the other four objectives from the Innovation Review. On those other objectives, the Payments System Board set out a proposed timeframe. It also offered one piece of guidance, namely the suggestion that it would be desirable to have all payments system participants connecting to a central hub or hub-like arrangement in any new payments infrastructure, as opposed to continuing with the numerous bilateral linkages that have proved to be not particularly conducive to either innovation or competition. Beyond that, the Board did not seek to dictate particular technical details of the solution, accepting that the industry itself should provide the roadmap to the agreed destination. One initial concern was that industry participants might respond with a number of separate solutions, but no clear path forward. APCA has played a constructive role in helping the industry to come together to form a project that will meet these four strategic objectives. BIS central bankers’ speeches Initially, a small committee developed a proposal for new payments infrastructure that is now being called the New Payments Platform. After this proposal was welcomed by the Payments System Board in February 2013, a broader group of 17 institutions came together to fund the initial development of the project. The participating institutions have been going through the final stages of vendor selection in the recent period. This has been an industry-driven process, in pursuit of the goals articulated by the Board, and to which the industry has committed. We have detected considerable interest internationally in this approach – not just the design features being proposed for the NPP, but also the way the central bank and the payments industry are seeking to work collaboratively to achieve major change. This approach, however, is not without its challenges. It requires that industry leadership and collaborative spirit to be maintained over a sustained period. At various key moments the project faces the risk of that spirit breaking down. The Reserve Bank is fully aware of how complex and far-reaching this project is, and how costly. Our own contribution to the settlements architecture is a major project for us as well. Having said that, let me also say, very clearly, how important the Bank sees it that the industry deliver on its collective commitment to deliver real-time, accessible payments to the community. The Bank is also aware that there could be a temptation along the way to seek to constrain the system, so as to conform to existing boundaries and business models. This is where the broader governance arrangements now in place need to take into account the interests of users and the need for the system to be open to competition, not just the interests of the existing players. We – the industry and the Reserve Bank itself – are building a piece of national infrastructure. We should take every opportunity to increase its potential value to the nation, rather than limiting it for fear of where it might take us. The biggest risk with this project is probably not a technical one. It is the risk that, in 10 or 15 years’ time, we will look back and see that we missed an important opportunity to provide something that will fully and efficiently support the payments needs of our economy. We owe our citizens a better outcome than that. We have to deliver, one way or another, the architecture and products that they will need into the future. It is not as though things are standing still in other jurisdictions. In the area of real-time payments, we have seen major initiatives launched in Sweden and Singapore – countries we would often view as comparators in terms of their income levels and market structures. The Swedish system was launched in December 2012 with a service known as Swish, which enables households to send real-time payments via their mobile phones on a 24/7 basis, 365 days a year. Singapore’s system, known as FAST, was launched in March this year. These two initiatives have wide participation, including by all the larger banks in those countries and many of the smaller institutions. There are some other countries, with lower income levels, lower penetration of electronic payments and without universally “banked” populations, that have also made the leap to fast retail payments. These include Mexico with its SPEI system, South Africa with Real-Time Clearing and India with its Immediate Payments Service. Is there a plausible reason to accept Australia falling behind? Delivering the NPP is also, in my opinion, in the interests of the Australian financial institutions, which are at the heart of payments today. It can be expected to lead to further growth in electronic payments and a reduction in costs. It will maintain the ongoing relevance of the current players. If those players do not provide Australian end-users with the services they want, surely others will seek to do so. Alternatively, the Reserve Bank would be duty bound to consider a regulatory approach. So our message to the industry is: stay the course. Continue the goodwill and prodigious effort that has brought you to this point. Deliver on the commitments you have collectively BIS central bankers’ speeches made. Let us together build a payments infrastructure that is efficient, open to competition and that will support innovation into the future. I thank APCA and its officers in particular for the efforts they have made, and continue to make, in the NPP and across the payments landscape. And I wish the broader payments industry success in its efforts to improve Australia’s payments system and look forward to ongoing cooperation between the Bank and the industry. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 10 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Australian Business Economists (ABE), Sydney, 13 November 2014. | Christopher Kent: The business cycle in Australia Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Australian Business Economists (ABE), Sydney, 13 November 2014. * * * I thank Natasha Cassidy, Vanessa Crowe, Emma Doherty, Craig Evans and Thomas Mathews for help in preparing these remarks. Introduction I’d like to thank the Australian Business Economists for the invitation to speak here today. It’s not surprising that after a period of sub-par growth in many parts of the world, we often hear the term “recovery” in discussion of current economic conditions and future prospects. For economists, the term recovery fits within the realm of business cycle analysis. At one extreme, it implies that the economy is near a low point in the cycle with the prospect of much better conditions ahead. A less extreme case would be one where growth has been below its trend (or potential) pace for a time, leading to a rise in unemployment and spare productive capacity more generally. In both cases, a period of above-trend growth would be required to reduce the unemployment rate and make use of that spare capacity. In my discussion today, I want to consider the extent to which either of these descriptions might be warranted, both here and offshore. This requires an assessment of where the economy has been, where it is now and where we think it is likely to be in the future. The first two parts of this are not always straight forward, and as for the third, the Bank regularly highlights the fact that forecasting is difficult and imprecise. 1 Also, conditions can vary somewhat across different parts of the economy. This is especially true of the Australian economy right now given the differences between the mining and non-mining sectors and some resulting variation in conditions across the states. State of the global economy Let’s start with a consideration of the state of the global economic business cycle. In terms of Australia’s real economy – by which I mean the production, trade and consumption of goods and services – what matters on the global front is the strength of our major trading partners. This can be measured by combining the growth of each of our trading partners using Australia’s export shares as weights (Graph 1). According to this measure, activity rebounded in 2010, following the worst of the global financial crisis. Since then, overall growth of Australia’s major trading partners has actually been relatively stable at close to its long-term average. In large part, this reflects the sizeable and increasing share of Australia’s exports going to our fast-growing neighbours in the Asian region, most notably China. The relatively weak growth among the advanced economies in recent years has had minimal impact on our major trading partners’ growth figure because they account for a small share of Australia’s trade (at least directly). 2 So, from the perspective of our major trading partners, growth has been average for a few years and our assessment is that this is likely to continue over the next two years. See, for example, the November 2014 Statement on Monetary Policy. In 2013, the G7 economies accounted for about 25 per cent of Australia’s exports directly, compared with about 40 per cent in 2000. And while Australia trades with these economies less than in the past, they still have an important bearing on global demand and supply conditions, thereby influencing the prices of our imports and exports. BIS central bankers’ speeches Graph 1 However, conditions in the major advanced economies are very important to Australia in other ways, via their effects on global financial conditions and through indirect trade linkages. 3 The economies of the United States, Japan and the euro area are in different phases of the business cycle; however, inflation is low and monetary policies remain very stimulatory in all. Stimulatory monetary conditions in those economies, including the exceptional expansion of their central bank balance sheets, has led to very low levels of interest rates globally and has contributed to a global “search for yield”, with important implications for exchange rates. After the recession following the global financial crisis, the recovery of the US economy is now well established. There has been a sizeable decline in the unemployment rate while wage growth and the rate of inflation have picked up a little of late (Graph 2). The Federal Reserve has now ended the extraordinary expansion of its balance sheet and markets are focused on the question of when the Fed might begin the process of raising its policy rate. This is generally anticipated to be sometime around the middle of next year. Once that process is seen to be starting in earnest (or at least much closer to starting), it may well lead to a further appreciation of the US dollar. The flipside of this would be a further depreciation of the Australian dollar, which remains above most estimates of its fundamental value, particularly given the substantial declines in commodity prices over the course of this year. Kelly G and G La Cava (2014), “International Trade Costs, Global Supply Chains and Value-added Trade in Australia”, RBA Research Discussion Paper No 2014–07. BIS central bankers’ speeches Graph 2 Unfortunately, the prospect of even the beginning of the normalisation of financial conditions is a distant one for both Japan and the euro area. Japan has made some progress over the past year or more in lifting GDP growth and inflation, and the labour market there is as tight as it has been in 15 years (based on the unemployment rate). However, growth of economic activity looks to have been rather subdued since earlier this year, wage growth is still very low (though edging higher), and consumer price inflation remains some way from the Bank of Japan’s 2 per cent target. Given that state of affairs, the Bank of Japan recently announced a significant expansion of its quantitative easing program. Meanwhile, the euro area is still close to the low point in its business cycle. Overall, growth of economic activity is modest at best. The unemployment rate has declined a little but it remains at a very high level. Inflation and inflation expectations have both declined over the course of this year to quite low levels, leading the European Central Bank to ease monetary policy further. In short, Australia’s major trading partner growth has been close to average and is likely to be around average, possibly even a touch higher, for the next two years. The major advanced economies are at different stages in the business cycle, but all still have very stimulatory monetary policies, which is keeping interest rates low globally. One consequence of the exceptional expansion of the central bank balance sheets of the major advanced economies is that the value of their currencies has been lower than would otherwise have been the case. Conditions in the advanced economies will be important for the Australian economy via global financial market conditions and exchange rates. BIS central bankers’ speeches State of the Australian economy How should we characterise the state of the Australian business cycle? The less extreme case I described at the outset is the relevant one. That is, the unemployment rate has risen gradually over the past couple of years to a level that is high relative to its recent history (Graph 3). That is consistent with below-trend growth of economic activity over that period. Growth over this financial year is likely to remain below trend, but our forecast is for growth to pick-up gradually to an above-trend pace by 2016. There are already signs of better growth in some parts of the non-mining economy, supported by the very low level of interest rates. Graph 3 Measures of aggregate activity When measuring economic activity, a lot of attention is paid to aggregate GDP. That’s appropriate given that it is a comprehensive measure of activity from the national accounts. The June quarter national accounts recorded an increase in GDP growth over the past financial year to a pace that was actually close to trend (in year-ended terms; Graph 4). Moreover, this pace was a bit stronger than we had forecast a year ago. BIS central bankers’ speeches Graph 4 However, the recently released annual national accounts data incorporated a downward revision to GDP growth, to 2.5 per cent in year-average terms for 2013/14. This was the same rate as the year earlier; it was a bit below trend and it was in line with our forecasts of a year ago. 4 The source of this downward revision was less growth of export volumes than earlier estimated, although export growth still remained strong. 5 Looking at more recent quarters, our assessment of a broad range of timely indicators of activity is that the moderate pace of growth recorded in the June quarter (0.5 per cent according to the quarterly national accounts) has been maintained over recent months. Pulling this all together suggests that growth has been below trend for the past two years or more. Measures of mining and non-mining activity Underlying the pattern of growth of aggregate economic activity, there have been some important differences across the mining and non-mining sectors. These differences are relevant to understanding the current state of the business cycle and the prospects for growth. As is well known, the economy is in the midst of the transition from the investment phase to the production phase of the resources boom. Mining investment has been declining for about two years now. At the same time, exports of resources have risen significantly as investment projects reach completion. Further rises in export volumes are in prospect, particularly as Until the September quarter national accounts are released in early December, we won’t know though what the revision to the annual figure implies for the quarterly pattern of growth. The downward revision to exports reflected shifting the reference year forward (to 2012/13). Given the decline in commodity prices, this has the effect of reducing slightly the contribution of resources exports to growth. BIS central bankers’ speeches liquefied natural gas (LNG) projects begin to ramp up production. However, because the production phase of the boom needs much less labour than the investment phase, this transition is freeing up labour from resource and resource-related activities. Given this, it makes sense to consider GDP growth excluding resource exports. This has picked up over 2013/14 (Graph 5). Nonetheless, it remains below its historical average. In large part, this reflects the decline in mining investment. And by our estimation, mining investment is set to decline more rapidly in the coming year or so than it has since it peaked in mid 2012. Graph 5 It also makes sense then to look at non-mining activity. This can be approximated as GDP excluding both resource exports and mining investment (net of imports). 6 Growth of this narrower measure of activity has increased over the past year and is, therefore, helping to offset the fall in mining investment, including by absorbing labour being freed up from the resources sector (Graph 6). Growth of non-mining activity is actually not that far from its historical average. Much of this improvement can be attributed to the very low level of interest rates. 7 The effect of this is perhaps most evident in the strength of housing market conditions, which are supporting strong growth of dwelling investment. This requires an estimate of imports used in mining investment. This is a rather imprecise exercise and so the estimates for non-mining activity should be considered as rough. The low growth of non-mining activity seen over the second half of the 2000s was not a sign of weakness in the economy overall, at least prior to the global financial crisis. Rather, the economy was growing strongly – as evidenced by the declining unemployment rate – with slower growth of non-mining activity offset by rising mining activity, particularly mining investment. BIS central bankers’ speeches Graph 6 Low interest rates, and higher housing prices, have also lent support to the growth of consumption, which has picked up over the past year or so, notwithstanding the weak growth of incomes. The strength of this effect is most apparent in those states for which housing market conditions have been strongest, namely New South Wales and, to a lesser extent, Victoria (Graph 7). These states are also less exposed to the effect of declining mining investment and commodity prices, which are weighing more heavily on Queensland and Western Australia. Graph 7 BIS central bankers’ speeches Meanwhile, non-mining business investment, after picking up following the global financial crisis, has been little changed now for three years. It remains very low as a share of nominal GDP. So the need for a recovery there is clear. To recap, various measures suggest that growth of aggregate economic activity has been a bit below trend for the past couple of years, consistent with the gradual rise in the unemployment rate over that period. Much of the growth of activity over the past year owes to the production and export of resources, which uses labour less intensively than other sectors of the economy. Even so, growth of non-mining activity looks to have picked up. The outlook for Australia’s economy So, what are the prospects for growth of activity and labour market conditions? Our expectation is that growth will continue to be a bit below trend for a time, picking up gradually to be a bit above trend pace by 2016. And the unemployment rate is likely to remain elevated for some time. The near-term weakness reflects a combination of three forces: a sharper decline in mining investment over the coming quarters than seen to date; the effects of the still high level of the exchange rate; and ongoing fiscal consolidation at state and federal levels. In contrast, resource exports are likely to make a further strong contribution to growth, with LNG exports expected to begin ramping up over coming quarters. At the same time, very low interest rates are working to support growth of household expenditure. In time, growth of household demand and the impetus to domestic demand provided by the exchange rate depreciation we have seen since early 2013 are expected to spur non-mining business investment. Given this outlook, I want to touch on two relevant aspects of the business cycle that are important sources of uncertainty for our forecasts. One is related to household consumption, the other to business investment. Household consumption At this phase in the business cycle, it’s natural to worry about the possibility that consumption will be weighed down by slow growth in household incomes, driven in turn by the subdued state of the labour market. It is true that stronger growth of employment and wages would provide more support for consumption. However, that dynamic usually kicks in later in the cycle. In the meantime, it’s reasonable to expect that very low rates of interest will enable and encourage households to shift some expenditure from the future to now, including via higher asset prices. This would see a decline in the share of disposable income that households save (i.e. a lower saving ratio). There are limits to this, and it would be unwise to build a recovery on a foundation of a sharp decline in the saving ratio. Our latest forecasts, however, suggest that there will be a gradual decline in the saving ratio over the next couple of years, of the same order of magnitude as we’ve already seen over the past couple of years. A decline in the household saving ratio would be consistent with the tendency for labour market developments to lag developments in economic activity, including consumption, by a few quarters. Consumption and GDP growth tend to pick up ahead of an improvement in employment growth, which would in turn be expected to occur before we see wage growth start to return to more normal levels. This was the case during the recessionary episodes of the early 1990s and following the global financial crisis (Graph 8). BIS central bankers’ speeches Graph 8 Non-mining business investment I’ve spoken at length recently about the factors that might have led to subdued non-mining business investment over recent years. 8 In short, I concluded that this outcome had been consistent with a period of greater uncertainty and below-average confidence. Both of these have changed for the better more recently, yet firms still seem reluctant to take on risks associated with substantial new investment projects. If the appetite of businesses (and shareholders) for risk were to improve, investment could pick up. It’s hard to know when such a turning point in spirits might take place. But it is more likely when the fundamental determinants of investment are in place as they seem to be now. The ready availability of internal and external finance, at very low cost, is one such element of that. Also, there is the stronger growth of demand across the non-mining parts of the economy over the past year or so and measures of capacity utilisation have increased to around long-run average levels. So there is a reasonable prospect of business investment picking up, in time. Even so, let me note some reasons why the anticipated recovery in non-mining business investment might not be quite as strong as in earlier episodes. But I will stress at the outset that if that comes to pass, it does not mean that growth of activity or of our prosperity need suffer. One reason why investment in the non-mining sector might be lower than in the past is that service industries account for an increasing share of our economy – rising by about 12 percentage points in terms of the employment share over the past three decades. This is relevant to investment because service industries, on average, have much lower levels of capital relative to labour (Graph 9). So, in an economy in which services account for a higher share of economic activity, other things equal, the optimal (non-mining) capital stock should Kent, C (2014), “Non-mining Business Investment – Where to from here?”, Address to the Bloomberg Economic Summit, Sydney, 16 September. BIS central bankers’ speeches be lower than it otherwise would be (as a share of that economy). 9 However, that doesn’t imply that GDP growth will be lower, nor does it suggest that the economy will be a less prosperous one. What matters for these things is whether we are taking advantage of profitable opportunities and using labour and capital in the most productive ways that we can. Also, it is worth emphasising that many services require high levels of human capital – in the form of education and training – which does not get picked up in investment as measured by the national accounts. Graph 9 Investment today might also be lower (as a share of nominal GDP) than in the past for another reason. Over time there has been a sizeable decline in the price of many types of machinery and equipment (particularly those related to information and communications). So, businesses are able to spend less to obtain a given level of capital services. For example, they can purchase a lot more computing power for a given level of nominal spending. Once again, if this leads to lower investment (as a share of nominal GDP) than in the past it does not imply less output growth or lower prosperity. Indeed, given that Australia imports much of our machinery and equipment, a lower price of that capital is to our benefit. Conclusions The major advanced economies are in different stages of the business cycle. The recovery from recession is well established in the United States, but has a long way to go in the euro area. Japan has made some progress in reducing the extent of spare productive capacity, but inflation is still some way from the Bank of Japan’s target. Nevertheless, growth of This is not to say that there hasn’t been a deepening in capital over time – that is, more capital per worker in both goods and services sectors. Rather, for a given increase in the number of workers, we need less investment just to keep the capital-to-labour ratio constant if a greater share of those workers are in the services sector than in the past. BIS central bankers’ speeches Australia’s major trading partners has actually been around average for some time now and, as best we can tell, it is likely to remain at that rate in the year ahead. Australian GDP growth has been a bit below trend pace over the past couple of years, consistent with a gradual rise in the unemployment rate. Much of the growth this past year owed to rising resource exports, although growth outside the mining sector also picked up. However, with mining investment set to fall more sharply over coming quarters, GDP growth is expected to be below trend for a time before gradually picking up to an above-trend pace by 2016. The very low level of interest rates is supporting, and will continue to support, growth of household expenditure. In time, this is expected to support a recovery in non-mining business investment, and the economy more broadly, including an improvement in conditions in the labour market. If history is any guide, the recovery is likely to proceed in that order, from household expenditure to business investment to labour market conditions. History also suggests that a pick-up in business investment (outside of the resources sector) will come, in time. The fundamental forces are in place to support that recovery. And while I have suggested some reasons why business investment might not be quite as strong as past episodes of recovery might suggest, these don’t imply that the economy overall will be less strong than otherwise, but rather just one element of expenditure that we measure via the national accounts. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 11 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 18 November 2014. | Glenn Stevens: Economic possibilities Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 18 November 2014. * * * I thank Elliott James for assistance in preparing these remarks Thank you again for inviting me to address CEDA’s Annual Dinner. Tonight marks the fifth time I have done so, and it continues a long tradition. My first venture to your gathering in 2006 talked about the role of finance in economic development. An important part of the story was that, through history, financial development and innovation went hand in hand with the extraordinary growth in living standards that flowed from the industrial revolution. Another part was that financial development did not come without its risks, which on various occasions in history had materialised in damaging, or even devastating, fashion. In 2006 we were talking, among other things, about the rise in debt of Australian households and the various risks that might accompany that. We had had a “stress test” focused on such issues, conducted as part of the International Monetary Fund’s Financial Sector Assessment Program. The results had been pretty good actually, but we were not sure how reassured we should be by them. And we talked about an increase in risk-taking in certain parts of the corporate sector that was occurring at the time, and wondered how that would all turn out. We didn’t have to wait long for answers to those questions. The next time I came to CEDA in 2008 the global financial crisis had erupted and the global economy and financial system were facing their darkest moments since the 1930s. The G20 Leaders had just met in Washington and taken the first steps towards putting the global financial system back on a sound footing. By then economic growth in Australia had already begun to moderate, but we feared a much more significant slowing could be in prospect. Confidence was shaken and, understandably, households and businesses became much more cautious about spending, taking on more debt, or investing in a new process or idea. The deteriorating global outlook also led to large declines in asset prices and the prices of commodities important for Australia. The feeling at the time was that the terms of trade, which had risen substantially as prices for minerals and energy had reached very high levels, had probably peaked. The falling terms of trade were expected to subtract noticeably from growth in national income over the subsequent period. It’s a matter of record that, due to a combination of factors, Australia’s economy and its financial system came through that real-life “stress test” remarkably well, all things considered. And, as it turned out, the boom in our terms of trade had further – a lot further – to run. By the time of the 2010 dinner, it was time to introduce this chart, which has been a feature of my presentations since then. The terms of trade had just broken through the peak of two years earlier and, on a five-year moving average basis, were at their highest level since Federation (Graph 1). Our assumption was that the terms of trade would probably peak that year, in 2010, before declining steadily over the next few years. BIS central bankers’ speeches Graph 1 Updating the chart two years later, that assumption was shown to be somewhat pessimistic. The terms of trade peaked in September 2011, about 12 per cent higher than we had previously forecast and 12 months later (Graph 2). The chart was by now sporting a decadelong average, to emphasise not just the level of the terms of trade but the persistence of the episode – even though we were not assuming it was “permanent”. Graph 2 The terms of trade had, however, finally started to decline. It has been a standard assumption since then that they would fall further. And so they have. In the latest version of the chart, the terms of trade have fallen by about 13 per cent since two years ago and by 22 per cent since their peak (Graph 3). As additional BIS central bankers’ speeches supply of commodities comes on line (including particularly from Australia) and demand grows perhaps more slowly than it has until recently, our best guess is that the terms of trade will fall further but remain at a level well above the standard of the past century. But of course, as this history amply demonstrates, such forecasts – all economic forecasts – have a wide range of uncertainty. This is something the Bank has emphasised more strongly over the past couple of years in our published material. Graph 3 The increase in the terms of trade prompted a surge in investment to increase supply of the commodities that were now commanding very high prices. Two years ago we expected capital expenditure by resources firms to peak at about 8 per cent of GDP and then decline. This updated chart shows what an extraordinary period of investment this was (Graph 4). Graph 4 BIS central bankers’ speeches The peak has been reached and mining investment has since declined to about 7 per cent of GDP. The detailed information we receive from liaison suggests that this decline has quite a long way to go yet, though there are still some large projects ongoing in the gas sector that will hold investment for a few years at what would once have been seen as very high levels. As the expansionary effect of very high levels of mining investment is unwound, even if only partly, other sources of demand will need to play a stronger part in driving growth in the economy. It’s very clear that growth in export volumes for resources is very strong. Indeed, the contribution of “net exports” to growth in real GDP has over the past year or two been the largest for more than a decade. Even so, we need stronger growth outside the resources sector. After several years of quite subdued growth, we estimate that non-mining activity has picked up some speed over the past year (Graph 5).1 But it would be good to see some further strength here, as the decline in mining investment activity continues. There are sufficient spare labour resources such that we could probably enjoy a couple of years of non-mining sector growth somewhat above its trend rate before we needed to worry too much about serious inflation pressure. The nonresource traded sector could contribute to such growth. The decline in the exchange rate will be of some help here, but the currency remains above most estimates of its fundamental value, particularly given the further declines in key commodity prices in recent months. An exchange rate more in line with fundamentals would be a helpful contributor to a balanced growth outcome. Graph 5 As for domestic sources of demand, an obvious contributor is the set of forces at work in the housing sector. Investment in new and existing dwellings is rising. It ought to be possible, if we are being sensible both on the demand management side and the supply side, for this to go further yet and, more importantly, for the level of activity to stay high for longer than the average cyclical experience. A high level of construction, maintained for a longer period of time, is vastly preferable to a very sharp boom and bust cycle. That alternative outcome might give us a higher peak in the near term, but then a slump in the housing sector at a time when the fall in mining investment is still occurring. A sustained period of strong construction will be more helpful from the point of view of encouraging growth in non-mining activity – and Estimating non-mining activity requires an estimate of imports used in mining activity. This is a rather imprecise exercise and so the estimates for non-mining activity should be considered as very approximate. BIS central bankers’ speeches also, surely, from a wider perspective: housing our growing population in an affordable manner. Considerations such as these are among the reasons we ought to take an interest in developments in dwelling prices, the flow of credit towards housing purchases, and the prudence with which these funds are advanced.2 It is perhaps opportune to offer a few observations on this topic. Having fallen in late 2010 and 2011, dwelling prices have since risen, with the median price across the country up by around $100 000 – about 18 per cent – since the low point. Prices have risen in all capitals, with a fair degree of variation: the smallest increase has been in Canberra, at about 6 per cent, and the largest in Sydney, at 28 per cent. Credit outstanding to households in total is rising at about 6–7 per cent per year. I see no particular concern with that. When we turn to the rate of growth of credit to investors in particular, we see that it has picked up to about 10 per cent per annum over the past six months, with investors accounting for almost half of the flow of new credit. It is not clear whether this acceleration will continue or abate. It is not clear whether price increases will continue or abate. Furthermore, it is not to be assumed that investor activity is problematic, per se. A proportion of the investor transactions are financing additions to the stock of dwellings, which is helpful. It can also be observed that a bit more of the “animal spirits” evident in the housing market would be welcome in some other sectors of the economy. Nor, let me be clear, have we seen these dynamics, thus far, as an immediate threat to financial stability. The Bank’s most recent Financial Stability Review made that clear. So we don’t just assume that all this is a terrible problem. By the same token, after all we have seen around the world over the past decade, it is surely imprudent not to question the comfortable assumption that it is all entirely benign. A situation where: • prices have already risen considerably in the two largest cities (where about a third of our population live) • prices are rising, at present, faster than income by a noticeable margin, and • an important area of credit growth has picked up to double-digit rates should prompt a reasonable observer to ask the question whether some people might be starting to get just a little overexcited. Such an observer might want to satisfy themselves that lending standards are being maintained. And they might contemplate whether some suitably calibrated and focused action to help ensure sound standards, and that might lean into the price dynamic, may be appropriate. That is the background to the much publicised comment that the Bank was working with other agencies to see what more could be done on lending standards. Let’s be clear what this is not about. It is not an attempt to restrain construction activity. On the contrary, it is an attempt to stretch out the upswing. Nor is it a return to widespread attempts to restrict lending via direct controls. That era, that some of us remember all too well, was one in which the price of credit was simply too low and credit growth too high all round. We don’t have that problem at present. That growth of credit to many borrowers The Reserve Bank does not take a doctrinaire view of the “correct” level of house prices. The endless discussion about whether or not the level of prices constitutes, at any one time, a “bubble” is not very productive. We can observe that, for more than a decade, the level of prices relative to disposable income has been noticeably higher than it used to be, and not just in Australia. If that is a bubble, it is a remarkably longlived and widespread one. But even if we lose no time arguing over that question, it is still the fact that prices go up AND down, and that these trends matter for the economy. If we are interested in strong and steady growth, we have an interest in dwelling prices and indeed all asset prices. BIS central bankers’ speeches remains moderate suggests that the overall price of credit is not too low. In fact the level of interest rates, although very low, is well warranted on macroeconomic grounds. The economy has spare capacity. Inflation is well under control and is likely to remain so over the next couple of years. In such circumstances, monetary policy should be accommodative and, on present indications, is likely to be that way for some time yet. But for accommodative monetary policy to support the economy most effectively overall, it’s helpful if pockets of potential over-exuberance don’t get too carried away. Turning from housing investment to investment more generally, a more robust picture for capital spending outside mining would be part of a further strengthening of growth over time. Some of the key ingredients for this are in place. To date, there are some promising signs of stronger intentions, but not so much in the way of convincing evidence of actual commitment yet. That’s often the way it is at this point of the cycle. Firms wait for more evidence of stronger demand, but part of the stronger demand will come from them. With respect to consumer demand, I should complete the picture by showing an updated version of the relevant chart from last time. In brief, not much has changed. The ratio of debt to income remains close to where it has been for some time (Graph 6). It’s rising a little at present because income growth is a bit below trend. Household consumption growth has picked up to a moderate pace and has actually run ahead of income over the past two years. Given that household wealth has risen strongly over that period, and interest rates are low, a modest decline in the saving rate is perhaps not surprising and indeed we think it could decline a little further in the period ahead.3 As I’ve argued in the past, however, we shouldn’t expect consumption to grow consistently and significantly faster than incomes like it did in the 1990s and early 2000s, given that the debt load is already substantial. Graph 6 See Kent, C (2014), “The Business Cycle in Australia”, Address to the Australian Business Economists, Sydney, 13 November. BIS central bankers’ speeches Productivity and competency When last I was here there were early signs of a pick-up in productivity growth, after a number of years of much slower growth. The most recent data, as measured, confirm that labour productivity has now grown faster over the past three years than it did on average over most of the 2000s (Graph 7). This is observable across a wide range of industries outside of the utilities and mining sectors, where some unusual forces have been at work. Graph 7 The standard caveats apply, of course, and it is too soon to draw strong conclusions. Nonetheless, the evidence is at least consistent with the hypothesis that productivity growth is on a better track than it was. Business models have been challenged by the substantial change occurring in the structure of the economy, itself a response to changes in relative prices, in technology, the high exchange rate and other forces. The good news is that businesses can respond to that, and they are doing so. This process will need to continue and, as you will recall, there is the “to do list” set out by the Productivity Commission.4 But there is also, I think, a broader set of questions increasingly being asked, about whether our overall business environment is conducive enough to risk-taking and innovation, and whether we are doing enough to develop the relevant competencies. The questions would include ones like: how easy is it to start a business? If the business fails, as many small ones do, is it easy enough to try again? How easy is it to hire employees? And to let them go if things don’t work out? The harder it is to do the latter, the more difficult it is to do the former. Are the rewards to a scientific/research career sufficient to attract a share of the best and brightest? What is the role of private sector support for research and development – as distinct from our rather heavy reliance historically on 4. See Banks G (2012), “Productivity Policies: The ‘To Do’ List”, Speech at the Economic and Social Outlook Conference, “Securing the Future”, Melbourne, November. Available at http://www.pc.gov.au/__data/assets/pdf_file/0009/120312/productivity-policies.pdf. BIS central bankers’ speeches government support? Is business itself doing enough? Does industry want to get more involved in research and developments? Does academia want to let it? Can private finance – be it banks, venture capital, “angel investors”, private equity and so on – get more involved in supporting innovation? Are the entrepreneurs who would like to receive such support prepared to submit to the accompanying discipline? We are talking about a much broader set of issues than just “competitiveness” as conventionally defined and discussed. We are really coming at the question of whether we have the competencies, across multiple dimensions, to be effective in the modern global economy. It is hard to evaluate that. These questions are not within my area of responsibility or competence, and I would hesitate to attempt a definitive answer. I note that others more qualified than I am have expressed various views and CEDA itself has done some interesting work relevant to these matters.5 But lest it all seem too hard, let me offer one perspective based on something that I have observed reasonably closely. Australia has just hosted the G20. Here was something global, complex and requiring careful leadership. Since we last hosted this gathering in 2006, the scale and complexity have grown almost beyond recognition. These days the Leaders meet annually and there are a host of ministerial and other meetings at various levels – around 60 formal meetings and related seminars in a year. There is the B20, C20, L20, Think 20, Youth 20 and various other groups. All these groups need to be accommodated and engaged. They all have their own agenda, but somehow we have to make them come together with the G20’s main agenda. At the same time, the main G20 agenda seriously needed to be streamlined and focused. The G20 needed to show that it could effectively meet the challenges of securing better economic performance – “strong, sustainable and balanced growth”. Australia is one of the smaller members of this group by GDP and certainly by population. We cannot match the scale of human resources available to larger countries in the various workstreams. We are geographically remote. We are not powerful enough simply to command attention or demand others follow our lead. If we are to be effective, we have to try harder than the average country. And it was our job this year to run this unwieldy body effectively. The feedback I have received from my counterparts has been universally and strongly positive. They judge that the Australian presidency has, by the metrics that count, been very successful. Prodigious efforts by exceptionally dedicated people in the public and private sectors ensured improvements to the agenda, process, logistics and conduct of meetings. Substantive things have been achieved by way of pro-growth commitments that, if carried through by the various jurisdictions over time, will make a material difference to wellbeing around the world. Achieving all this was costly in human and financial resources. It required coordination between multiple organisations. It was not on the scale of running the Olympic Games, but it was nonetheless a big deal and it was done well. It wasn’t achieved by any effortless superiority; it owed to careful preparation, astute use of some of our natural advantages and continuous effort over a long period. But that’s where success always comes from, really. The only question is: how badly do we want it? See Chief Scientist for Australia (2014), “Senate Inquiry Submission – Australia’s Innovation System”, Submission to Senate Inquiry into the Australian Innovation System, 23 July. Available at http://www.chiefscientist.gov.au/wp-content/uploads/Chief-Scientist-submission-to-Senate-inquiry-intoAustralias-Innovation-System1.pdf; and CEDA (2013), “Australia Adjusting: Optimising National Prosperity”, November. Available at http://www.ceda.com.au/media/338287/cedaaustadjusting_web.pdf. BIS central bankers’ speeches Responsibility for the G20 now passes to Turkey. We can bask in the glow of success for a few weeks and then get on to other matters. The point simply is that this has gone well as a result of the determined efforts of a range of people who were clear about what they wanted to achieve and who mobilised the necessary resources and effort to get there. One other result of Australia’s leadership of the G20 is that the whole issue of infrastructure is well and truly on the table. No one doubts the need for infrastructure provision and it has clear economic attractions. Spending on infrastructure supports aggregate demand during construction but, if done well, also augments the economy’s supply capacity for the long run. It is also clear from the various discussions over the past year that there is not a shortage of capital in global markets to fund infrastructure projects. The issues to be overcome don’t include finding the money. They concern appropriate project selection criteria, long-term planning, governance, contract design, appropriate risk sharing between public and private sectors, pricing usage of the infrastructure and so on. There is an opportunity here, including for Australia, to do something of value over the years ahead. Of course, we will need to be serious and to put in the effort over an extended period – in all the above areas. If we don’t put in that effort, not much actual infrastructure will be delivered. But if we are serious, a lot could be achieved. I imagine that the Committee for the Economic Development of Australia would be keen to be involved. Conclusion I have reached the limits of our time this evening. Australia’s economy is continuing to grow, moderately. It has been responding in ways you would expect to the remarkable set of circumstances it has faced over the past decade. There is continuing adjustment ahead and doubtless no shortage of challenges. But beyond these challenges of the next couple of years, maximising our economic possibilities in the modern world requires sustained efforts at adaptation and innovation, at doing things better and, perhaps most of all, a willingness to take the occasional risk. I would be confident that we have, or can develop, the relevant capabilities. The only question is whether we are sufficiently determined to succeed in deploying them. Bibliography Gillitzer C and J Kearns (2005), “Long-term Patterns in Australia’s Terms of Trade”, RBA Research Discussion Paper No 2005–01. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 11 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists (ABE) Annual Dinner, Sydney, 25 November 2014. | Philip Lowe: Building on strong foundations Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Australian Business Economists (ABE) Annual Dinner, Sydney, 25 November 2014. * * * I would like to thank David Jacobs for excellent assistance in the preparation of this talk. Thank you for inviting me back to the Australian Business Economists’ annual dinner. It is an honour for me to be able to speak again in front of so many of Australia’s leading business economists. Before I turn to my main topic this evening, I would like to pay tribute to one of my predecessors who passed away earlier this month – and that, of course, is John Phillips. John served the Reserve Bank of Australia (RBA) (and before that the Commonwealth Bank) for more than four decades, and between 1987 and 1992 sat in the office that I now occupy. John epitomised the first of the RBA’s core values – that of serving the public interest. He did this with great dedication during his time at the RBA and in his highly distinguished subsequent career. At the RBA, John worked tirelessly to modernise Australia’s financial and monetary system, and to modernise the RBA itself. The institution that I now serve, as well as the broader Australian community, owe him a considerable debt. John will be sorely missed. When I last spoke at this dinner, two years ago, the title of my remarks was “What is Normal?”. 1 My thesis was that as a country, we were going through a difficult adjustment in expectations. Over the decade or so to the late 2000s we had got used to consumption growing more quickly than income. We had also got used to asset prices, credit and fiscal revenues growing more quickly than income. We had got used to employment increasing more rapidly than the working-age population. And we had got used to growth in our real incomes outpacing the rate at which we were improving our productivity. We started to think that this was normal. Retailers thought it natural that their sales grew more quickly than people’s incomes. Many investors thought that earning capital gains on their existing assets was the key to wealth creation. Banks got used to very fast growth in their balance sheets. And we all got used to the annual tax cuts that came from strong revenue growth. But these trends were not normal. And so two years ago, my thesis was that the dawning realisation of this was affecting the national psyche. Two years on, I think we better appreciate the uniqueness of the earlier episode and there has been some realignment in expectations. But I suspect that this realignment is not yet over and it is one of the things that continues to weigh on the national economic mood. Also weighing on this mood is the prospect of the so-called “end” of the mining boom. As a result, I sense a degree of nervousness about our future among some commentators who sometimes ask: what happens to Australia after this boom is over? how can Australian businesses compete internationally given our high costs? and, where will the jobs come from in the future? These are all good questions. But if I return to another theme from two years ago, it is that uncertainty is also normal. Given this, it is important that we guard against the possibility that this uncertainty mutates into chronic pessimism – that is, for it to become normal for us to See Lowe P (2012), “What is Normal?” Address to the Australian Business Economists Annual Dinner, Sydney, 5 December. BIS central bankers’ speeches think that our prospects are limited. If this were to become our normal mindset, then we would be well on the way to finding ourselves in the very world that we feared. So this evening, I would like to turn my eyes to the future and talk a little about how the economy might look someway down the track. My central thesis tonight is twofold. First, the Australian economy does have the foundations for a successful and prosperous future. And second, how well we take advantage of those foundations depends increasingly on investment not in physical capital, but in human capital. An aspiration So looking forward, what type of economy should we be aspiring to? One could answer this in many different ways. But I think a reasonable answer would be a highly productive, globally competitive economy that is operating close to, or at, full employment. Such an economy would be characterised by: a national currency with sustainably high purchasing power; sustainably high real wages; and sustainably high real returns on capital. High purchasing power and high wages mean that for each hour that we work we are able to buy more goods and services. And high returns mean that savers get rewarded when they take a risk or defer their spending and save for the future. If we are to meet this aspiration then we need to be an economy where value added is high. We need to be able to produce a range of goods and services very efficiently and/or be able to sell goods and services at a premium price because of their quality, their uniqueness or some other favourable attribute. This is true right across the industry spectrum. It is true in advanced manufacturing. It is true in the tourism industry. It is true in agriculture. And, it is true in the technology sector and in business and household services. In the end, it is unlikely that we can achieve this aspiration by simply selling standardised, homogeneous, mass-produced goods and services on the world market. We need to be at the high valueadded end in much of what we do. And this is why investment in human capital is so important. It is through human capital that we can create the goods and services that can deliver on this aspiration. The quality of our human capital is critical to our ability: to solve complex problems; to develop and use technology; to deliver premium quality goods and services; and to respond quickly and well to an ever-changing world. So one of the challenges that lies ahead is to create the environment that encourages the investment in human capital that is ultimately required to sustain the high living standards and high returns to savers that we should be aspiring to. I want to return to this challenge in a few moments. Cyclical considerations Before I do, though, it is important to recognise that the exchange rate, wages and the return to saving each also play a key role in how the economy is performing at any point in time. In terms of the exchange rate, the RBA has been saying for a while now that a lower value of the Australian dollar would be helpful from an overall macroeconomic perspective. If the exchange rate is to play its important stabilising role, it needs to go down when the terms of trade and investment are declining, just as it went up when the terms of trade and investment were rising. To date, as we expected, we have seen some adjustment, but if our assessment of the fundamentals is correct we would expect to see more in time. In terms of wages, there is sometimes commentary bemoaning their high level in Australia. There are, no doubt, certain areas where wages are very high and working conditions are highly favourable and some adjustment is likely to be required. But it is also useful to recall BIS central bankers’ speeches that over the past two decades or so, aggregate wage outcomes have been consistent with the inflation target and with a trend decline in the unemployment rate. They have also been associated with a fairly low share of wages in national income. While we need to pay close attention to overall labour costs, these observations point to the conclusion that concerns about the overall level of wages in Australia are, to some extent, really concerns about the exchange rate, with the high exchange rate leading to high wages expressed in foreign currency terms. A lower exchange rate would obviously make a difference to these comparisons. In terms of the return to saving, it is currently very low. As I spoke about last month, this largely reflects global factors. 2 A lack of investment around the world, relative to people’s desire to save, means that savers everywhere are being offered low returns on their savings in bank accounts. This is causing them to look elsewhere, which, in turn, is pushing up the price of existing assets. So from a cyclical perspective – and largely as a result of global factors – our exchange rate is unusually high and, at the same time, savers are being offered unusually low returns. Of course, Australia is not unique in being in this position. And this particular configuration is causing complications for macroeconomic management here as well as in a number of other countries. But as we deal with these complications we should not lose sight of the longer-term challenge of building a highly productive, globally competitive economy. We should have some confidence that we are able to do this. We certainly have a number of strong foundations that provide the basis for this optimism. The question is how well we can use those foundations over the years ahead. Some strong foundations Rather than go through all of these strong foundations, I would like to draw your attention to just three. The first is our linkages with the fastest growing part of the world economy – namely Asia. I am sure you all know the facts about the trade relationship. Exports to Asia are up by around 30 per cent over the past five years. Our three largest export destinations – China, Japan and South Korea – are all in the Asian region and free trade agreements have been concluded with each of them recently. But the aspect of the relationship that I would like to focus on is the people-to-people relationship. Currently, around 8 per cent of the Australian population was born in east and south-east Asia or India (Graph 1). This is up from less than 1 per cent of the population around the time that I was born. In comparison, in the United States, only around 3½ per cent of the population was born in Asia and for most European countries the figure is below 2 per cent. See Lowe P (2014), “Investing in a Low Interest Rate World”, Address to the Commonwealth Bank of Australia’s 7th Annual Australasian Fixed Income Conference, Sydney, 21 October. BIS central bankers’ speeches Graph 1 There are also large numbers of students from Asia studying in Australia. Currently there are around 150,000 Chinese student enrolments at Australian educational institutions, more than double the number a decade ago (Graph 2). There are also large numbers of students from India, South Korea, Malaysia, Thailand, Vietnam and Singapore. All up, there are more than a quarter of a million Asian students studying here. In time, these students will add to the already vast network of our alumni across the region. Graph 2 The strong people-to-people linkages can also be seen in the broader data on international short-term arrivals (Graph 3). At the moment, more than 250,000 citizens from Asia are travelling to Australia every month, with arrivals from China reaching nearly 80,000 a month. As is evident from the graph, these figures have grown very strongly over recent years. There has, of course, also been very strong growth in the number of Australians travelling to Asia for both business and leisure. BIS central bankers’ speeches Graph 3 Taken together, this deep and growing people-to-people engagement is an increasingly important national asset. It helps us better understand the most dynamic part of the global economy. It promotes goodwill and can help identify cross-border business opportunities. Some of the students studying here will hopefully become “champions” for our country when they return home. Others will remain here and use their knowledge and relationships in their country of birth to build new and stronger business ventures between our countries. The second foundation that I would like to point to is our strong overall population growth. Over the past decade, Australia has had almost the fastest rate of population growth in the OECD and this is expected to continue for some time to come (Graph 4). In a decade’s time, our population is forecast to be 17 per cent higher than it is today – that is an extra four million people. Graph 4 These people will require somewhere to live, to work and to play. This population growth helps underpin the creation of new opportunities for businesses and for individuals. It means that people can plan with the knowledge that the overall size of the pie is getting bigger. BIS central bankers’ speeches Contrast that to the situation in Japan where, over the next decade, the population is expected to decline by about as many people as currently living in Melbourne. In Australia, we are likely to add roughly another Melbourne to our population over this period. The third foundation that I want to point to is our considerable endowment of natural resources, both in terms of minerals and agricultural land. One illustration of the recent benefit that Australia has gained from its minerals is the large rise in export revenue. For many years, revenue from resource exports was equivalent to around 5 to 7 per cent of GDP, but recently it has averaged double this, at around 12 per cent of GDP (Graph 5). With a large increase in LNG exports still to take place it is possible that this ratio will increase even further, although this will also depend on how the prices of our exports evolve. Graph 5 While not all the extra revenue accrues to Australian residents because of the high levels of foreign ownership in the resources sector, this increase has helped boost our average standard of living. Notwithstanding the current focus on the decline in mining investment, we should not lose sight of the fact that this extra export revenue, which has been made possible by the investment in extra capacity, has made us better off and has created opportunities that we would otherwise not have had. In terms of strong foundations, I could have also talked about our strong institutions, our capable public sector, our generally flexible economy, a strong financial sector, low levels of government debt and generally healthy corporate balance sheets. Collectively, these various factors have helped deliver average living standards in Australia that are among the highest on the planet, and they have given us opportunities that are available to only a few other countries. Taking advantage of the opportunities? How then do we make the best of these opportunities? There is of course no single answer here. But I find it difficult to escape the conclusion that investment in human capital is central to taking advantage of the opportunities that we have built for ourselves. Looking at where the jobs have been created over the past couple of decades, two trends stand out. The first is the fact that the largest increase has been in jobs with higher level qualifications (Graph 6). The second is that, in terms of industries, the bulk of the new jobs have been in services, with over 3½ million service industry jobs having been created since BIS central bankers’ speeches the early 1990s (Graph 7). These jobs are in health, education, personal services, retailing, finance, engineering, information technology, software design, telecommunications – the list goes on. In contrast, just over half a million jobs have been created in the so-called goodsproducing industries – manufacturing, mining, construction and utilities. And given the first trend, many of these jobs – both in the services and in goods-producing industries – have required higher levels of skills. Graph 6 Graph 7 BIS central bankers’ speeches It would seem, therefore, that our future is increasingly dependent upon high-level cognitive skills and our ability to understand and solve complex problems. It depends upon having people who are curious, who are able to grasp new opportunities and who are able to transform and interpret information in new ways. And it depends on having the interpersonal skills to provide the premium services that will attract the premium price. Business practices everywhere are being reshaped and disrupted by developments in information technology. This is true not just in the service industries but also in manufacturing, with much of today’s innovative capital equipment as dependent on the software that runs it as it is on the quality and ingenuity of the physical engineering. How to best take advantage of this new world is not the core expertise of the central bank. But I would like to make three observations. The first is the importance of culture. The type of human capital that is likely to be required in this world is best developed in a culture that promotes and rewards innovation and excellence, whether it is in services, goods, resources or agriculture. 3 It is best developed in a culture that encourages entrepreneurship and for people to take a risk with a new idea. And it is best developed in a culture that promotes creativity and flexibility. Developing and sustaining such a culture takes effort across a whole range of areas. So if we hope to make the best of our opportunities then we should all be asking what we can do here. The second observation is the importance of ensuring that our workforce has an appropriate mix of sophisticated skills to produce premium goods and services. These skills are those required to solve complex problems, identify new opportunities and deliver high-quality customer experiences. Creativity – in all its dimensions – is a key element here. One of the areas that deserves close attention is the STEM subjects – science, technology, engineering and mathematics. Over the years, Australia has done reasonably well here, but the share of Year 12 students studying higher level mathematics and the sciences has been in decline for many years now (Graph 8). 4 I might also add that in our schools, considerably more young men study many of these subjects than do young women. Unfortunately, this is also true for the study of economics. In terms of the international tests, our scores have been relatively high, although they too have tended to slip a bit over recent years (Graph 9). 5 Looking beyond the STEM skills, we need to build a creative, innovative and flexible workforce. See Australian Government (2014), Industry Innovation and Competitiveness Agenda, Commonwealth of Australia, Canberra. Available at http://www.dpmc.gov.au/publications/Industry_Innovation_and_Competitiveness_Agenda/docs/industry_innov ation agenda.pdf Kennedy J, T Lyons and F Quinn (2014), “The Continuing Decline of Science and Mathematics Enrolments in Australian High Schools”, Teaching Science, 60(2), pp 34–46. See Thomson S, L De Bortoli and S Buckley (2013), PISA 2012: How Australia Measures Up, Australian Council for Educational Research, Camberwell, Victoria. Available at <http://www.acer.edu.au/documents/PISA-2012-Report.pdf> BIS central bankers’ speeches Graph 8 Graph 9 And the third observation is the need to find ways of deepening collaboration between our universities and businesses. Australia has some tremendous places of higher learning. But as a number of reports have recently highlighted, the collaborative research connections between these universities and private business are not well developed by international standards. 6 According to many For example, see OECD (2013), OECD Science, Technology and Industry Scoreboard 2013: Innovation for Growth, OECD Publishing, available at BIS central bankers’ speeches entrepreneurs, strong collaboration and networking are critical elements in the development of the type of innovation ecosystems in which new ideas can best flourish and be commercialised. So this is an area to which we need to pay close attention. Conclusion I know I have strayed a long way from the setting of the cash rate, which I also know is of keen interest to many of you. But, in a very real sense, the issues that I have spoken about tonight do have implications for monetary policy. The reason that the world has such low interest rates at the moment is that people’s desire to save outstrips their desire to create new assets. A stronger global investment environment would be likely to see global interest rates rise and this is something that we should all hope occurs sooner rather than later. The issue that many countries are struggling with is how to do this – that is, how to improve the investment climate. Very accommodative monetary policy is playing a role here. But there are some real limitations to this and, in some countries, these limitations are becoming increasingly evident. What is needed is a genuine improvement in the underlying investment climate. And so this is where the issues that I have talked about tonight come in. The Australian economy clearly has some challenges ahead, but we would be selling ourselves short if we dwelt exclusively on these challenges. Our economy does have some very strong foundations upon which we can build – I have talked about our links with Asia, our dynamic population and our natural resources. These foundations give us opportunities that few countries have. They should also provide us with some confidence that new investment can deliver reasonable returns. This sense of confidence would be enhanced by further steps to improve the environment for the accumulation of human capital. If we are able to do this, then I hope that it would become normal for us to live in a highly productive, globally competitive economy with sustainably high living standards and returns to savers. Thank you for listening and I look forward to any questions that you might have. Bibliography Kennedy J, T Lyons and F Quinn (2014), “The Continuing Decline of Science and Mathematics Enrolments in Australian High Schools”, Teaching Science, 60(2), pp 34–46. <http://www.oecd-ilibrary.org/science-and-technology/oecd-science-technology-and-industry-scoreboard2013_sti_scoreboard-2013-en>, and Schwab K (ed) (2013), The Global Competitiveness Report 2013–2014, World Economic Forum, Geneva, available at <http://www.weforum.org/reports/global-competitiveness-report2013-2014>. BIS central bankers’ speeches | reserve bank of australia | 2,014 | 11 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the 27th Australasian Finance and Banking Conference, Sydney, 16 December 2014. | Guy Debelle: Liquidity Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the 27th Australasian Finance and Banking Conference, Sydney, 16 December 2014. * * * Thanks to Jon Cheshire and Sean Dowling for assistance. Today I will talk about the imminent arrival of the revised liquidity regime for the Australian financial sector. I will recap some of its features, particularly how they relate to the Reserve Bank, and discuss some of the impact that it is having on market pricing. An important aspect of the Basel III liquidity standard, the Liquidity Coverage Ratio (LCR), comes into effect in under one month’s time at the beginning of 2015. The LCR requires that banks hold sufficient ‘high quality liquid assets’ (HQLA) to withstand a 30-day period of stress. The amount of HQLA a bank needs to hold is determined by the composition and maturity structure of its balance sheet. The more liabilities that run off within that 30-day window, the more HQLA that needs to be held. At the same time, particular types of investors or depositors are assumed to be less stable than others (in terms of their likelihood of withdrawing funds), which also results in a greater need for liquid assets. As has been known for some time, the Australian financial system does not have an especially large stock of HQLA. 1 The only instruments that have been deemed to meet the Basel standard of liquidity are debt issued by the Commonwealth and state governments (CGS and semis) along with cash balances at the Reserve Bank. The banking system’s overall liquidity needs are greatly in excess of what could reasonably be held in those assets. To put some numbers on this, APRA has determined that for next year, the Australian banking system’s liquidity needs amount to $450 billion. The total stock of CGS and semis on issue currently amounts to around $600 billion. If the banks were to attempt to meet their liquidity needs solely by holding only CGS and semis, a number of problems would arise. Firstly, any attempt would likely be in vain, because there are a large number of other entities which are required to or want to hold CGS and semis too. Second, in the process of trying to do this, the liquidity of the market for these securities would be seriously compromised. This would be completely self-defeating as the overall aim is to have the banks hold more liquid assets. To address these circumstances, an important component of the liquidity regime in Australia is the committed liquidity facility (CLF) where, on the payment of a 15 basis point fee, banks will be able to obtain a commitment from the Reserve Bank to provide liquidity against a broad range of assets under repurchase agreement. 2 APRA has recently determined that the total CLF requirements of the Australian banking system for 2015 amount to around $275 billion. 3 This amount was determined by first assessing that the amount of CGS and semis that could reasonably be held by banks without unduly affecting market functioning was $175 billion. The Reserve Bank provided this See APRA (2014), ‘Implementation of the Basel III Liquidity Framework in Australia’, Media Release No 14.03, 30 January, available at <http://www.apra.gov.au/MediaReleases/Pages/14_03.aspx>; and Debelle G (2012), “Regulatory Reforms and their Implications for Financial Markets, Funding Costs and Monetary Policy”, Address to the Financial Services Institute of Australia, 18 September. Domestic Market Operations – The Committed Liquidity Facility. See APRA (2014), “APRA Finalises Implementation of Liquidity Coverage Ratio in Australia”, Media Release No 14.22. Available at <http://www.apra.gov.au/MediaReleases/Pages/14_22.aspx>. BIS central bankers’ speeches assessment to APRA. The CLF amount is then simply the difference between this and the overall liquidity needs of the system. The banks that require a CLF from the Reserve Bank sign a deed of agreement with us and pay their fee before the end of this year. Then from the beginning of next year, the arrangement comes into effect. I have talked before about some of the impact on pricing in various markets of the new liquidity regime. 4 We have attempted to limit the impact on the price of CGS and semis, but necessarily, because the banks are holding more of these securities than previously (Graph 1), the price is higher (and the yield lower) than would otherwise be the case. Graph 1 Overall, the impact of the LCR on market pricing is relatively small. The larger changes have been around deposit pricing and the terms and conditions of deposits, which I will come to shortly, but there have been some other effects which are worth commenting on. Firstly, a less discussed aspect of the liquidity standard is the requirement for a demonstrated internal liquidity transfer pricing model for banks. This has required banks to fully reflect the liquidity cost in the price of the various services they offer customers. This has resulted in a change in the price and/or terms and conditions of a number of facilities. One noteworthy example is a line of credit where, in the past, banks often did not factor into the price they charged for this facility, the potential draw on liquidity this entailed, particularly in a stressed situation. On the other hand, longer fixed-term deposits are more attractive to banks and consequently have been repriced upwards (see below). A second impact which has been evident more recently is a widening in the spread between bank bills and OIS (Graph 2). In the depths of the crisis, such a widening was often an indicator of stress in the financial situation. But that does not appear to be the case currently as other indicators of bank creditworthiness are little changed, including spreads on longer term borrowing and CDS premia. Debelle G (2012), “Regulatory Reforms and their Implications for Financial Markets, Funding Costs and Monetary Policy”, Address to the Financial Services Institute of Australia, 18 September. BIS central bankers’ speeches Graph 2 Instead, our assessment is that in large part, this reflects the new liquidity regime combined with some other dynamics in the market. The graph shows that the widening has been most pronounced at the longer bank bill maturities, and indeed is quite small for a one month bank bill. This is because issuing a one month bill has little attraction to a bank: its liquidity cost is relatively high as its maturity is likely to occur within the 30-day liquidity window. Hence a bank would need to hold HQLA of similar size to the amount of funding the bank bill raised. Instead, there is a greater incentive to issue at longer maturities and so the spread on 6-month bills has widened by more as there has been greater supply of such paper. Over the past two months, the original term to maturity of bank bills and certificate of deposits on issue has changed noticeably, with the stock of 6-month bills increasing by $7.3 billion (11 per cent) and 12-month bills by $1.4 billion (43 per cent). In contrast, the stock of outstanding bills with an original tenor shorter than five months has declined by a total of $9.7 billion (8½ per cent). At the same time, the cost of Australian dollars in the forward FX market has been quite elevated. This high price in the forwards market has been due to a number of factors including the tendency of hedge funds to fund their Australian dollar shorts in this market, as well as an increase in the use of this market by foreign bank branches to fund Australian dollar lending. Historically, Australian banks have tended to raise a significant share of their short-term funding in foreign markets, mostly in US dollars, and then swap them back into Australian dollars to fund their Australian dollar-denominated asset base. They would swap these foreign currency funds when the cost was sufficiently attractive, leaving it in foreign currency in the interim. Under the new liquidity regime, the cost of short-term foreign currency funding is higher, so this is less attractive. Combined with a higher swap cost, the all-in cost of shortterm offshore funding is higher and hence domestic issuance is relatively more attractive. As a result we have seen more of it, which has contributed to the widening in the spread to OIS. Finally, I will return to the impact of the LCR on deposit pricing. Graph 3 shows the evolution of the funding mix of Australian banks over the past decade. The rise in the share of deposit funding from 2008 is readily apparent, as is the decline in the share of short-term and longterm wholesale funding. The growth in deposits is now of a similar pace to that in bank lending, having been considerably faster over recent years. As a result, the deposit share of funding has levelled off. BIS central bankers’ speeches Graph 3 The increase in deposit funding was in part a result of the increased returns on offer, as banks actively sought this outcome by offering higher interest rates. (It also reflected a shift on the part of investors for the perceived safety of a bank deposit.) The interest rate on both at-call and term deposits rose markedly compared with money market rates of equivalent maturity (Graph 4). As you can see from the graph, this process of paying higher deposit rates has largely run its course. Graph 4 BIS central bankers’ speeches Within this overall repricing, there have been some changes in the mix of deposit rates and products as a result of the introduction of the LCR. As I mentioned earlier, banks have an incentive to reduce the amount of liabilities that roll off in less than 30 days. Deposits which are deemed to be subject to high run-off rates and those which are callable within 30 days will be more expensive for banks. Banks are therefore working towards converting many of these less stable deposits into a more stable deposit base. For example, retail and SME deposits are deemed to be ‘stickier’ than institutional deposits. Part of this transition is being induced by price signals: interest rates offered on new or existing deposit products which are deemed to be more stable are rising relative to interest rates on products deemed to be less stable. These types of changes appear to have accelerated recently as we draw closer to the implementation of the LCR and probably still have some way to run. To date, we have seen only a few banks offer notice of withdrawal accounts to customers. These accounts require the depositor to provide the bank with 31 days or more notice of a withdrawal (obviously 31 days is one day longer than the 30-day liquidity stress period). Interest rates offered on these accounts are among the higher rates offered in the deposit market. It may be that we see a broader move to these types of accounts or changes in terms and conditions on existing accounts through the course of next year. We have also seen a fall in the growth of term deposits relative to transaction and at-call deposits over the past few years. In fact term deposits as a share of banks’ funding has been falling while transaction and at-call deposits have been growing strongly. Part of this is because a flattening of the yield curve has made investors less inclined to invest in longer term deposits. But in part it is because under the LCR, some transactional and operational deposits are subject to lower run-off rates than deposits that are largely attracted by higher interest rates. Indeed, there has been some indication that banks have been transitioning depositors into deposit products treated more favourably under the LCR. But banks are not limited to just changing their deposit offerings. We could see them look for more opportunities to package retail deposits with other products as the deposits of customers that also have other relationships with the bank are deemed to be more stable under the LCR. So to conclude, the full implementation of the new liquidity regime in Australia is imminent. From the beginning of next year, banks in Australia will be fully subject to the Liquidity Coverage Ratio. This has already had an impact on the pricing and nature of a number of financial products, as well as the structure of bank liabilities. While the bulk of the impact may be behind us, there are still a number of changes in the pipeline, particularly around deposits. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 1 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the launch of the Official Australian Renminbi Clearing Bank. Sydney, 9 February 2015. | Glenn Stevens: Remarks at the launch of the Official Australian Renminbi Clearing Bank Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the launch of the Official Australian Renminbi Clearing Bank. Sydney, 9 February 2015. * * * Premier, Consul General, Mr Chen, distinguished guests, colleagues, ladies and gentlemen, thank you for the invitation to say a few words on the occasion of the launch of the Bank of China (Sydney) as the official renminbi clearing bank here in Australia. Today’s events mark an important step in the further development of a local renminbi – or RMB – market. But more than that, they mark one more step in a lengthy and very important journey that has seen the flowering of trade relations between China and Australia, and which promises benefits from the maturing of financial ties. On its own, the key direct benefit of the official Australian RMB clearing bank is that it can more efficiently facilitate transactions between Australian firms and their mainland Chinese counterparts using the Chinese currency. Bank of China (Sydney)’s “official” status – which was granted by the People’s Bank of China (PBC) – affords it more direct access to the Chinese financial system, with flow-on effects for local financial institutions and their customers. But an official Australian RMB clearing bank also confers some indirect benefits on the Australian financial sector and its customers, particularly when viewed as one element of a broader range of initiatives. In particular, the establishment of the clearing bank helps to raise awareness among Australian firms that the local financial system has the capacity to effect cross-border RMB transactions on their behalf. This is important, because over the long run, Chinese firms may increasingly wish their trade with Australian firms to be settled in RMB. To be sure, today the bulk of global trade is settled in US dollars. But with China now a very large trading nation, and continuing to grow into a “continental sized” economy, it would be surprising if at some point we do not see much more use of China’s currency for trade purposes. Already its usage is growing quickly, if only from a small base. So Australian firms and the Australian financial system need to be well prepared. To that end, the RBA has been directly involved in several initiatives, with the aim in each instance being to ensure that there are mechanisms in place that allow the private sector to increase its use of the Chinese currency as and when it chooses to do so. This of course included the signing of a Memorandum of Understanding with the PBC to enable the establishment of an official RMB clearing bank in Australia, in November last year following the G20 Leaders’ Summit in Brisbane. In addition, there was the establishment of a bilateral local currency swap line with the PBC in 2012, which is designed to provide confidence to both Chinese and Australian financial institutions that appropriate RMB and AUD liquidity arrangements are in place in the event of dislocation in the market. More recently, there was the negotiation of a quota to allow financial institutions based in Australia to invest in approved mainland Chinese securities under the Renminbi Qualified Foreign Institutional Investor Scheme – better known as RQFII. Finally, I note the RBA has invested a small proportion of Australia’s foreign currency reserves in RMB. Official initiatives like these help to lay the groundwork. But ultimately, the development of an RMB market in Australia will depend on the extent of benefit the private sector sees in using BIS central bankers’ speeches RMB for trade settlement and investment purposes. It is worth noting that private sector-led initiatives are now becoming increasingly important drivers of the RMB market’s development. For example, forums such as the Australia-Hong Kong RMB Trade and Investment Dialogue and the “Sydney for RMB” Working Group are beginning to have a more prominent role in raising awareness of the financial sector’s capacity to conduct RMB business and in identifying any further market development issues that may need to be addressed. Looking ahead, and as my colleague, Deputy Governor Philip Lowe has noted a number of times, the process of RMB internationalisation and the associated opening of China’s capital account are likely to have significant implications for the global financial system – much like the opening up of China’s current account has had a very large impact on the global economy.1 The Chinese authorities have indicated that they intend to continue RMB internationalisation and capital account liberalisation in the coming years. As a result, the opportunities for Australian and Chinese investors to invest in each other’s financial markets could grow significantly in the coming years. By increasing their familiarity with the RMB as an international transaction currency, local financial institutions, investors and firms are likely to be better placed to take advantage of these future opportunities as they arise. I congratulate the Bank of China (Sydney) on the official launch of RMB clearing facilities in Sydney. This is a further important step in what continues to be a fascinating journey. For example, see: Lowe P (2014) “Australia’s RMB Policies and Future Direction”, Introductory Remarks at the RMB Internationalisation Roundtable, Sydney, 23 July; and Lowe P (2014) “Some Implications of the Internationalisation of the Renminbi”, Opening Remarks to the Centre for International Finance and Regulation Conference on the Internationalisation of the Renminbi, Sydney, 26 March. 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Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the FX Week Australia Conference, Sydney, 12 February 2015. | Guy Debelle: FX benchmarks Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the FX Week Australia Conference, Sydney, 12 February 2015. * * * Similar remarks are also contained in an article in the Euromoney Foreign Exchange & Treasury Management Handbook 2015 (forthcoming). Today I will talk about benchmark rates in the foreign exchange (FX) market. FX benchmarks are an important part of the financial market infrastructure. They are referenced in many financial contracts and are particularly prevalent in global bond and equity market indices where they are used to aggregate markets into a common currency. The longstanding approach to do this has used a set of foreign exchange rates calculated at a particular time of day, generally 4pm London, the London “fix”, which is published by WM/Reuters (WMR).1 Attention on this arcane part of the financial market infrastructure has increased significantly over the past couple of years as concerns mounted about the integrity of benchmark rates and the possibility of market misconduct around the benchmark fixing process. Following investigations by a number of authorities, some of these concerns have proven to be well founded, and investigations are ongoing. Reflecting the emerging concerns about the FX benchmark process, in early 2013 the Financial Stability Board (FSB) tasked a group chaired by Paul Fisher of the Bank of England and me to formulate a set of proposals to improve the benchmark process and reduce the scope for manipulation. Our work was conducted completely separately from the investigations into allegations of FX manipulation and we did not have access to any of the evidence gathered by those investigations. The Foreign Exchange Benchmark Group (FXBG) was comprised of members from all the major financial centres. We talked extensively with most parts of the FX industry to get their views, including asset managers, index providers, FX platforms, corporates and banks. A preliminary report was released for public comment in July last year and we received a good amount of constructive feedback on it.2 The final report of the FXBG was presented to, and approved by, the Financial Stability Board last September.3 I have had a number of people ask what status the report has. The answer is that it has been approved by the FSB, a body which consists of heads of central banks, securities regulators and ministries of finance/treasuries of all the major jurisdictions. The report contained 15 recommendations aimed at improving the benchmark process and reducing the incentives for manipulation. The recommendations garnered broad support across the industry. We are now several months on from the release of the report, so it is useful to see what has been achieved in that time. My general assessment is that there has been significant progress on some recommendations but little on others. WM publishes reference rates throughout the course of the day. The London 4pm rate is by far the most heavily used. There are a number of other reference rates, with the 2.15pm CET rates published by the European Central Bank quite widely used. FSB (2014), “Public Responses to July 2014 Consultative Document Foreign Exchange Benchmarks”, 20 August. Available at <http://www.financialstabilityboard.org/2014/08/c_140819/>. FSB (2014), “Final Report on Foreign Exchange Benchmarks”, <http://www.financialstabilityboard.org/2014/09/r_140930/>. BIS central bankers’ speeches September. Available at The recommendations addressed both the structure of the benchmark process as well as the conduct of participants in the process and can be divided into four main areas: benchmark methodology; execution infrastructure; market conduct; and guidance on central bank reference rates (which I won’t cover today). The group believed that the recommendations it made would be implemented by the market participants concerned and indeed, as I just said, they were supported by market participants at the time and endorsed by the FSB. There is a strong expectation they will be implemented. The recommendations are, however, not explicitly embodied in regulation. Nevertheless, the group stated that if these recommendations were not acted on, authorities could conclude that a regulatory response was necessary to generate the desired improvement in market structure and conduct. Moreover, as a result of the investigations into the alleged misconduct, a regulatory response may be required and indeed, in the UK, FX benchmarks are now a regulated activity. The UK Fair and Effective Markets Review (FEMR) has also actively sought feedback on such issues.4 The calculation of the fix The first set of recommendations concerned the calculation of the London 4pm fix. For a number of years, WM has calculated the fix over a one minute window centred on 4pm. WM calculated the fix using data from either Thomson Reuters or EBS (depending on the currency pair). It took snapshots of trade and order rates at one second intervals and calculated the (unweighted) median rate over the minute window. That is, the fix is calculated based on executed prices, in contrast to LIBOR which was a submission-based process. Hence the issues which we needed to address in the case of FX benchmarks differed from those associated with the old calculation methodology for LIBOR. While we concluded that the WM benchmark calculation methodology was essentially sound, the group recommended widening the window from one minute to enhance the robustness of the fix calculation. The wider window should reduce the capacity for manipulation while still generating a replicable market price. The group also recommended that rather than use generally only one price feed, WM incorporate feeds and transactions data from more sources into its calculation, provided the additional sources were of sufficient quality and representative of the market. While arbitrage should ensure that the single data sources used by WM should be representative of the market, we thought it relatively costless to use a wider range of sources and this would be beneficial in getting a “truer” picture of the market over a short time frame. WM has subsequently announced that it will widen the fix window to five minutes commencing on 15 February.5 It will also utilise additional price feeds from that time. In addition, the group recommended that WM form a user group to consider future changes to the fix calculation methodology. In announcing its recent changes to the calculation of the fix, WM sought feedback from the industry and is in the process of establishing such a user group. Finally, WM has agreed to follow through on a number of recommendations made by IOSCO which assessed WM’s fixing processes against the IOSCO principles for benchmarks.6 Details of the FEMR are available on the Bank of England website at <http://www.bankofengland.co.uk/markets/Pages/fmreview.aspx>. Submissions closed at the end of January. See <http://wmcompany.com/wmr/index.htm>. IOSCO (2013), “Principles for Financial Benchmarks: <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD415.pdf>. Final Report”, July. Available at BIS central bankers’ speeches Infrastructure of the fix The next set of the group’s recommendations addressed the market infrastructure around fixing trades, that is, how fixing trades are executed in the market. The aim here was to reduce the incentives and opportunity for misbehavior generated by the market structure. The FXBG report documented the concentration of activity through the fixing window. It noted that trading volume at that time was up to 10 times larger than at other times in the trading day. A major source of the large volume of these trades is likely to be asset managers seeking to rebalance their portfolios in line with the indices they track that incorporate the London fix in their calculation. One way to minimise this tracking error between their portfolio and the foreign exchange component of the index they are tracking is obviously to execute at the fixing price itself. Orders for these trades and other fixing trades are provided by the client to the FX dealers ahead of the fix (often this time is quite short). Importantly, the dealer typically agrees to execute these orders at the, as yet unknown, fix price and often does not charge either a fee or spread on the trade. These arrangements differ from standard principal-based risk transfer services offered by dealers, where the risk to the dealer is mitigated by using the current market price and applying a spread. The arrangements for fix-related orders mean that the price risk on the transaction is transferred entirely from the client to the dealer without any compensation. The dealers then have to manage the risk associated with this flow. The trades conducted as a result of this process can generate optics of dealers trading ahead of the fix, even if the dealer is simply seeking to manage the risk. But these dynamics can also create an incentive for dealers to manipulate the fix rate to generate profit from what would otherwise be potentially a loss-making exercise. To address this problem, the FXBG supported the development of industry initiatives to create independent netting and execution facilities for transacting fix orders. A number of such products have been launched on the market in recent months. They generally have the feature of maximising netting opportunities and then executing the order in a way that delineates the separation between the dealer trading on its own account and the dealer transacting on behalf of the customer. It remains to be seen how much traction these products will get. In our preliminary report, the group had sought market feedback on the development of a central netting utility to maximise netting opportunities and reduce the need for customers to provide orders in advance of the fix to dealers. While some of the feedback was supportive, others confirmed some of the potential practical problems that such a utility might confront, particularly around the execution of the residual positions once all netting opportunities had been exhausted, which would determine the fixing price. Market conduct The above recommendations address the structure of the foreign exchange market around the fix. The FXBG believes the recommended changes will improve outcomes but at least as importantly, it provided a set of recommendations about the behavior of market participants on all sides of the market: dealers, asset managers, index providers, to address the possible incentives for manipulation. First, the group recommended that the FX dealers charge for fixing transactions in a more transparent manner (rather than for example, relying on the business being subsidised by activities in other parts of the dealers’ institution). This charge might be implemented either through a fixed fee or a spread. A fixed fee would be consistent with an agency mode of fixed execution. A spread is consistent with compensation for the risk transfer where the bank is BIS central bankers’ speeches acting as principal. The shift to a wider window for the fix calculation means that the risk transfer is likely to be larger for the bank in being able to replicate the fixing price. While a number of banks have started to discuss this with their customers and are in the process of moving to charge for this service, this recommendation is not being adopted universally at this point. Not surprisingly, there has been push back from some customers against paying for something that had been previously offered for free (at least notionally). So long as some dealers remain willing to not charge directly for this service, competitive forces mean that it is difficult for others to charge. There is clearly a first-mover disadvantage. More progress is required here. When WM implements the wider window later this month, this may prove a focal point for a shift in pricing models. There have been various media reports in recent days suggesting that a number of banks are doing this. However, if the fixing service is not directly and transparently charged for, the incentive for inappropriate behaviour remains. Second, the group recommended that banks and other FX dealers separate their fixing business from their regular business. The primary aim of this recommendation was to reduce the likelihood of inappropriate use of the information obtained from the fixing orders. Clearly, such a separation is not costless and it does reduce risk absorption opportunities. Nevertheless, the group’s assessment was that the benefits would outweigh the costs. Some banks have implemented this recommendation over recent months but adoption has been somewhat mixed. I have received a number of questions about what exactly separation entails. We did not intend to be too prescriptive here. The main principle is the appropriate segregation of the information flow. There may be a number of different ways of achieving this. An issue which arises here is that the separation of business is clearly more complicated in smaller currencies than it is in the more heavily traded currencies. In response to these issues, I will consult with my fellow central banks and securities regulators on these questions and determine if more guidance can be given around this. Third, the group made a number of recommendations around the appropriate sharing of information. These recommendations focused on general principles around information sharing. The group’s assessment was that outlining a set of principles was more beneficial in ensuring appropriate behavior than more prescriptive statements. Detailed prescriptions run the risk of being incomplete with the potential for market participants to make the assessment that if something was not in the prescriptions then it must be allowable. A set of principles require market participants to think more carefully about their general approach to information sharing. Codes of conduct A similar set of principles are to be embodied in a code of best market practice and shared global principles, which is currently in the final stage of being written jointly by the various foreign exchange committees. The aim is to promote a set of shared global principles common across all the FX committees, notwithstanding the fact that the various jurisdictions employ different codes of conduct. A final version of the statement of shared principles should be published following the next global meeting of foreign exchange committees in Tokyo in March. The FXBG also recommended that market participants should demonstrate stronger compliance with the various codes of conduct than has been the case in the past, as well as with their own internal codes. Various initiatives are under way on this recommendation at both the institutional level as well as with the market as a whole. Appropriate enforcement of these codes remains a major challenge. In the UK, the FEMR highlights this issue as a significant opportunity for reform. BIS central bankers’ speeches Much of this comes down to ensuring that the institution, and the FX market more generally, has the appropriate culture. But the same problem arises with codes of conduct as with the principles for information sharing I talked about a minute ago. If the codes of conduct are too prescriptive, they are very difficult to draft, they quickly become unreadable and they run the risk that if something is not explicitly prohibited, it must be okay. Matt Levine articulates this problem very succinctly: “If you don’t define ‘culture’, it’s hard to enforce it. If you do, it’s going to be gamed.”7 Index providers During its work, the group discovered that there was considerable variation in the understanding of index providers about the way the FX rates they used in their indices were calculated. Hence the group recommended that index providers consider whether the FX fixes they used in their calculation are fit for purpose. Asset managers Similarly, in the course of our consultation with the market, the group found there was considerable variation among asset managers in their understanding of the FX rates used in the indices they were tracking and, perhaps more importantly, considerable variation in understanding how their FX fixing business was being executed in the market. While asset managers should be able to assume that the market infrastructure was adequately robust and that their counterparties conducted themselves with some degree of appropriate behaviour, at the same time, greater scrutiny and enforcement from market participants is desirable. Hence the group recommended that asset managers conduct appropriate due diligence around the FX execution and be able to demonstrate that to their clients if requested. Clearly, such due diligence would be consistent with the asset managers’ regular fiduciary responsibility to their clients. While some asset managers have done this for many years as part of their standard operating procedure, there remains scope for further adoption of this across the asset management industry and, more generally, a greater understanding of the way their FX business is executed in the market, as it becomes an increasingly important component of asset managers’ portfolios. The way forward The 15 recommendations of the group have been adopted to varying degrees, but there is still substantial scope for further progress in some areas. The recommendations to enhance WM’s calculation of the London fix are well in train. There are a number of initiatives in the marketplace to provide independent fix execution and netting. Codes of conduct remain a work in progress, particularly in terms of their enforcement, though the various foreign exchange committees are working with a common purpose on this currently and I expect that we will have something concrete to show for this very shortly. However, there has yet to be significant progress in terms of the pricing and execution of the fix business within institutions. On pricing, while there may be more than one way of charging for the fix business that could be adopted, there needs to be a widespread adoption across the industry. On the separation of the fixing business, the primary objective is separation of Levine M (2015), “Levine on Wall Street: Culture and Retaliation”, BloombergView, 2 February. Available at <http://www.bloombergview.com/articles/2015–02–02/levine-on-wall-street-culture-and-retaliation>. BIS central bankers’ speeches the information flow. There are, again, a number of potential solutions to this and I accept there may be some scope to provide more guidance around this recommendation, particularly in the case of less-traded currencies. To conclude, there is a strong expectation that these recommendations will be implemented to deliver an improvement in the execution of foreign exchange transactions referencing FX benchmarks and the integrity of the benchmarks themselves. The FSB has approved the recommendations contained in the FX Benchmark Group’s report. If these recommendations are not implemented, then the likelihood of a regulatory response will increase. 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Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 13 February 2015. | Glenn Stevens: Overview of economic developments affecting Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 13 February 2015. * * * Chair Members of the Committee Since the hearing in August last year, the economy has continued to grow at a moderate, but below-trend pace. Inflation as measured by the CPI has been affected by movements in energy prices and government policy changes, but even aside from these effects, inflation is low and appears likely to remain so. The international context is one in which the global economy likewise is growing, but according to most observers at a pace a little below its longer-run average. There are some notable differences in performance by region. The US economy has picked up momentum, growing above trend with a falling unemployment rate. China’s economy met its growth target in 2014. A slightly lower target seems likely to be set for 2015, perhaps something like 7 per cent. But that would still be robust growth for an economy of China’s size. On the other hand, the euro area and Japan have recorded lower growth rates than expected a year ago. Commodity prices have fallen, in some cases quite sharply. These trends appear to reflect primarily major increases in supply, with some moderation in demand playing a role. That would appear to be the case for iron ore and oil prices (and, prospectively, liquefied natural gas prices, which are typically tied to oil prices). Base metals prices, where few significant supply changes have occurred, have fallen by much less. So there has been what economists refer to as a “positive supply shock”: more of the product is available with lower prices. The effect of this on individual countries will vary, depending on whether they are a producer or a consumer of such raw materials. On the whole for the global economy, however, this is a positive development. Inflation is quite low in a range of countries, and very low in some. The decline in energy prices is temporarily pushing headline CPI inflation rates even lower. The very low interest rates in evidence around the world when we last met have fallen further. This has been most pronounced in Europe, where yields on long-term German sovereign debt have fallen to be about the same as those in Japan. German sovereign debt has recently traded at negative yields for terms as long as 5 years. Official deposit rates are negative in the euro area, and the European Central Bank has announced a large-scale asset purchase program – colloquially referred to as “quantitative easing”. The euro has depreciated. Some surrounding countries to which funds tend to flow in anticipation of further depreciation – such as Switzerland – have reduced interest rates to significantly below zero and indeed 10-year Swiss government debt has traded at a negative yield. The Swiss National Bank took the decision to remove the cap on the Swiss franc, as it assessed that the size of the intervention likely to be required to hold it was becoming just too large. This move occasioned considerable turbulence in foreign exchange markets. Meanwhile, the US Federal Reserve, faced with a strengthening US economy and having ended its asset purchase program last year, is expected to begin a gradual process of lifting its policy rate in a few months from now. So the monetary policies of the major jurisdictions look like they will be heading in differing directions. This means there is ample potential for further turbulence in financial markets this year. The falls in prices for key export commodities are lowering Australia’s terms of trade and hence the purchasing power of our national income. This is a well-understood mechanism and has been the subject of much discussion. It will continue to constrain income growth for BIS central bankers’ speeches households and mining companies, and revenues for both state and federal governments, over the period ahead. Resource export shipments are increasing strongly, as the capacity put in place by the period of high investment is put to use. At the same time, the high levels of capital spending by the resources sector, which had been a strong driver of domestic demand for several years, peaked during mid 2012 and turned down. All indications are that this downswing will accelerate this year. That has always been our forecast. The recent declines in commodity prices don’t change it, though they do reinforce that this trend is well and truly under way. The various areas of domestic demand outside mining investment are mixed. Dwelling construction is rising strongly and commencements of new dwellings will reach a new high over the coming 12 months. Consumer spending is responding both to income trends and financial incentives, which are pulling in different directions. Growth in wages, by historical standards, is quite subdued. This and the fall in the terms of trade is working to restrain growth in disposable incomes. Working the other way, the fall in petrol prices, assuming it persists, is adding noticeably to the real incomes of consumers. Increased asset values, which push up gross measures of wealth, and low interest rates are also working to push consumption up relative to income. The net effect of these opposing forces is producing moderate, though not strong, consumption growth. Meanwhile, at this point non-mining business investment spending is still very subdued. While several key fundamentals are in place for stronger performance, clear signs of a nearterm strengthening remain unconvincing at this stage. This is a weaker outcome than we had expected six months ago. Public sector final spending – about one-fifth of aggregate demand – is fairly subdued, and the intent of governments, as you know, is to restrain their own spending over the period ahead. The lower exchange rate is likely to help export volumes outside the resources sector, and of late better trends have been observed in some services export categories including tourism and education. Overall, growth in non-mining economic activity has picked up, but is still a little below average. Our expectation had been that a further pick-up would occur in 2015. When we reviewed our forecasts in late January, we didn’t feel that growth in the recent past had been materially different from what we had estimated a few months ago. But when we tried to look ahead, we concluded that there were fewer signs of a further pick-up in non-mining activity than we had hoped to see by now. As a result, the revised forecasts we took to the February Board meeting embodied a longer period of below-trend growth, and a higher peak in the rate of unemployment, than earlier forecasts. They also suggested that inflation was likely to remain pretty low over the forecast horizon. The inflation outlook was revised slightly lower, in part reflecting the effect of declining oil prices as well as the weaker outlook for economic activity. At its meeting in February the Board considered that this revised assessment – that is, sub-trend growth for longer, a higher peak in the unemployment rate, slightly lower inflation – warranted consideration of some further adjustment to monetary policy, after a fairly long period during which the cash rate had remained steady. These were incremental changes to the outlook but all in a consistent direction. Another factor in our consideration was dwelling prices, which have continued to increase. Price rises in Sydney are very strong, and they are pretty solid in Melbourne. On the other hand they are much more mixed elsewhere. Excluding Sydney, the rise for Australia as a whole over the past year was about 5 per cent. That is a healthy pace but not alarming, and some cities have seen price falls. Developments in the Sydney market remain concerning, but in the end we did not see these trends as overwhelming a case for a further easing in monetary policy that was made on more general grounds. I note that, on the regulatory front, APRA has announced its supervisory approach to managing the potential risks posed by the rise in lending to investors in housing. This involves more intense scrutiny of investor loan portfolios growing at over 10 per cent per BIS central bankers’ speeches year, with the possibility, ultimately, of additional capital being required if APRA deems it necessary. APRA has also reiterated its expectations for other elements of lending standards such as interest rate buffers and floors. And ASIC has begun a review of interest-only lending in the context of consumer protection legislation. The Bank welcomes these steps and will keep working with other regulators in these areas. The Board is also very conscious of the possibility that monetary policy’s power to summon up additional growth in demand could, at these levels of interest rates, be less than it was in the past. A decade ago, when there was, it seems, an underlying latent desire among households to borrow and spend, it was perhaps easier for a reduction in interest rates to spark additional demand in the economy. Today, such a channel may be less effective. Nonetheless we do not think that monetary policy has reached the point where it has no ability at all to give additional support to demand. Our judgement is that it still has some ability to assist the transition the economy is making, and we regarded it as appropriate to provide that support. The forecasts published last week in the Statement on Monetary Policy assume a lower path for interest rates and a lower exchange rate than both earlier forecasts and the ones the Board responded to at the February meeting. These are assumptions rather than forecasts or commitments to a course of action. It is worth noting that, despite concerns at various times about whether the exchange rate would adjust appropriately to our changing circumstances, it has been doing so over the period since we last met with the Committee. Against the US dollar it has fallen by around 17 per cent since our last hearing. The US dollar itself has been rising against all currencies, of course, so much of this movement is an American story rather than an Australian one. Against a basket of relevant currencies the Australian dollar has fallen by less, but the decline is still about 11 per cent since August. Further adjustment is probably going to occur. One other development since our last meeting with the Committee was the final report of the Financial System Inquiry. This was quite a wide-ranging report and there is now a further period of consultation. I simply note that the Inquiry did not find major problems in the financial system, but did make recommendations about capital, to enhance the resilience of the banking system, and about loss-absorbency more broadly in the context of resolution. These will be mostly in the province of APRA to consider. The Inquiry also made some observations about payments matters, generally supporting the steps the Payments System Board has taken since its inception in 1998, and pointing to some areas where further steps may be appropriate. The Payments System Board will be considering these matters at its meeting next week. We now await your questions. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 2 |
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Goldman Sachs Annual Global Macro Economic Conference, Sydney, 5 March 2015. | Philip Lowe: Low inflation in a world of monetary stimulus Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Goldman Sachs Annual Global Macro Economic Conference, Sydney, 5 March 2015. * * * I would like to thank Marion Kohler for excellent assistance in the preparation of these remarks. Accompanying charts can be found at the end of the speech. I would like to thank Goldman Sachs for the invitation to speak today. It is a pleasure to be here and be part of your annual Macro Economic Conference. It is perhaps stating the obvious to say that an important part of the macroeconomic environment is monetary policy. The actions of central banks have material effects on financial markets and can shape macroeconomic outcomes. Indeed, over recent decades it became widely accepted that monetary policy was the primary macroeconomic stabilisation tool and that monetary policy could effectively manage the business cycle. From today’s perspective, the picture looks a little different. In many ways, the current global monetary environment is quite extraordinary. There has been unprecedented money creation by the world’s major central banks. Policy interest rates are negative across much of Europe. Long-term government bonds yields in most advanced economies are the lowest in recorded history. Lending rates for many private sector borrowers are the lowest ever. And some banks in Europe are now charging customers to accept deposits. In earlier eras, one could have predicted with some confidence that this type of monetary stimulus would have created a boom in economic activity and subsequently a substantial lift in inflation. Yet, today, many parts of the world continue to operate with considerable spare capacity, inflation rates are low almost everywhere and inflation expectations have generally declined, not increased. So this afternoon, I would like to talk a little about these very unusual times. I will begin by showing a few graphs that summarise the current global monetary environment. I would then like to explore some of the possible reasons why we are in this environment before addressing some of the implications of all this for Australia. The current global monetary environment So first, to the facts. Since the global financial crisis, we have seen an extraordinary increase in the size of central bank balance sheets. This first graph shows the size of the combined balance sheet of the US Federal Reserve, the Bank of Japan and the European Central Bank (Graph 1). This combined balance sheet has increased from the equivalent of US$3½ trillion in early 2007 to almost US$10 trillion today, and a further substantial rise is in prospect. Once this further increase has occurred, the combined balance sheet will be equivalent to around 35 per cent of the relevant countries’ collective GDP, up from just 10 per cent prior to the crisis. This increase has taken place primarily by the central banks creating money to purchase assets outright from the private sector. The next graph shows a long time-series of nominal 10-year government bond yields for a number of advanced economies (Graph 2). The striking thing is how low these rates are now. The German and Japanese Governments can borrow for 10 years at less than 0.4 of a percentage point, while the US and UK Governments pay 2 per cent or less. At shorter maturities, investors are prepared to actually pay governments to look after their money. And it is not just governments that can borrow at negative rates, with yields on the bonds issued by some highly rated corporations also turning negative recently. BIS central bankers’ speeches With nominal rates so low, real long-term government bond yields in much of the world are negative. One way of calculating these real rates is to subtract the central bank’s inflation target from the nominal 10-year yield. The results of this are shown in this next graph (Graph 3). If the central banks do achieve their inflation targets (and there is some doubt that this will be the case), the current yields imply very large real losses for the holders of some sovereign bonds. For example, if the Bank of Japan was to achieve its inflation target over the next decade, then current holders of 10-year Japanese government bonds would lose around 15 per cent of their investment in real terms. The same is broadly true in Germany. And in the United States, the real return over the next 10 years would be zero. The next graph shows current headline inflation rates for a number of countries as well as the midpoint of the relevant inflation target or objective (Graph 4). In all advanced economies, inflation is currently below target and this is also true in quite a few emerging market economies. Of course, one reason for the low inflation rates is the recent large decline in oil prices. But even so, as is evident from the following graph (Graph 5), core or underlying rates of inflation are also below target almost everywhere. So to summarise briefly, the current environment is one in which there has been a very large monetary stimulus, interest rates are very low and inflation is subdued. This is not exactly what the traditional textbooks would have predicted. Why do we find ourselves here? The obvious questions that arise here are why do we find ourselves in this situation and what does it say about the effectiveness of global monetary policy? One answer is that the current environment simply reflects the extreme nature of the financial crisis and that monetary policy is working pretty much as it always has. In a number of dimensions the crisis was the biggest financial shock since the Great Depression in the 1930s. It led to major stresses in bank and government balance sheets and badly dented confidence. Monetary policy responded to this, with the size of the response commensurate with the size of the shock. According to this line of argument, what is unusual about the current environment is not the magnitude or the effectiveness of the monetary response, but rather the magnitude of the underlying problem to which monetary policy is responding. An alternative answer is that the effects of monetary policy have been somewhat less, or slower to materialise, than in earlier times. Partly as a result of this, the monetary response has needed to be larger. This line of argument recognises the considerable damage caused by the financial crisis, but sees economic activity and inflation responding in only a relatively muted way to the monetary stimulus, with central banks having to do more to achieve their mandated goals. There is probably an element of truth in both of these answers. The shock caused by the financial crisis was indeed a very large one and a very large monetary response was appropriate and helpful. At the same time, though, the transmission of the monetary stimulus does look to have been a little different through this episode. Economic activity does not appear to have responded to the stimulatory monetary conditions in the way that occurred in the past and inflation rates have been very low. Perhaps the single most important factor explaining this is the very high levels of debt that exist in many advanced economies. One of the channels through which monetary policy works is by encouraging people to bring forward future spending to today. This requires them to borrow or to reduce their rate of savings. In the years leading up to the crisis, a reduction in interest rates could be reliably predicted to encourage such a response. Credit was easily accessible, economic volatility in many economies was low and people were prepared to borrow. BIS central bankers’ speeches In today’s world, things look quite different. After a steady increase in debt levels over the previous two decades, many people do not want more debt (Graph 6). They do not want to – or they do not have the confidence to – bring forward future spending to today. As a result, household indebtedness in many countries has declined even though interest rates are the lowest on record. One area where low interest rates do appear to be having the broadly expected effect is on asset prices: global equity markets have been strong; property prices are again recording solid gains in some countries; and bond prices have increased substantially. However, for these increases in asset prices to boost the global economy, households and businesses need to respond by increasing their spending. While in the United States there are now some signs that this is happening, on the whole the response of private spending to higher asset prices has been muted. Overall, looking at this experience, I find it difficult to escape the conclusion that changes in interest rates are not affecting decisions about spending and saving in the way they might once have done. Undoubtedly, low interest rates are helping to repair balance sheets by lowering debt-servicing costs and by pushing up asset prices. In so doing, they are helping lay the foundations for future growth in consumption and investment. But, while this repair process is taking place, consumption is weaker than it otherwise would be. In turn, subdued consumption growth is feeding through to a more subdued business climate and weaker investment. Arguably, a similar dynamic has been playing out in government finances in a number of countries. After the financial crisis, many governments found themselves with debt levels that were very high (Graph 7). Like many households, they have responded by tightening their belts. Given the high levels of debt and ongoing imbalances between recurrent revenue and expenditure, few governments have seen the very low interest rates as an opportunity to support long-term infrastructure investment at low cost. Rather, much as households have done, governments have taken advantage of the lower debt-servicing costs to help shore up their finances. A second part of the monetary transmission mechanism that looks a little different is the flowon from economic activity to inflation. While the evidence here is less clear cut, looking around the world it seems probable that both workers and firms perceive that their pricing power has declined. To the extent that this has occurred, it is likely to have come from a combination of the scarring experience of the financial crisis and of the increasing globalisation of many markets. Over recent years, wage outcomes have been very subdued in many countries. This is true not just in those countries with high unemployment rates, but also in those with low unemployment rates. In Germany, the unemployment rate is the lowest in more than 30 years and in Japan it is the lowest in around two decades. Yet, in both countries, wage outcomes are subdued. More broadly, across a range of countries, wage increases have recently been slower than suggested by standard Phillips Curve relationships. This comes after a period in which the wage adjustments to very high unemployment rates were relatively small in a number of countries. Time will tell if this simply reflects a change in the normal lags. But I suspect that there is something deeper going on. The experience of the financial crisis has left deep scars in many economies, including a heightened sense of job insecurity. This insecurity has been compounded by the increased competition that globalisation has brought as well as by changes in technology. It has led to many workers in advanced economies feeling less inclined to seek the wage increases that they might once have sought – they feel that they have less market power and that keeping a job is more important than seeking a large pay increase. A similar dynamic is probably playing out in the pricing decisions of many businesses. Globalisation has brought new competition in many markets for goods and services and the BIS central bankers’ speeches financial crisis increased business uncertainty. In this environment, putting up prices can seem to be a more risky proposition than it did previously. It is difficult to tell how persistent any of these perceived changes in market power are likely to be. It still seems highly probable that a period of strong growth in the global economy would eventually see a generalised increase in pricing power. In the meantime, though, the inflation pressures in the global economy are quite muted. The recent fall in oil prices has reinforced this and has contributed to a decline in inflation expectations in a number of countries. In this environment, the limits of monetary policy are becoming more visible than perhaps they were in earlier years. High levels of debt and increased uncertainty look to have changed or, at least temporarily, altered the transmission mechanism. This is one of the reasons why the G20 and others have focused on the importance of structural reform and improving the climate for investment. At the global level, stronger and more effective policies in these areas would be helpful in encouraging both households and businesses to take advantage of the opportunities that low interest rates have provided. Monetary policy can help support the global economy, but ultimately it cannot be the fundamental driver of economic growth. Implications for Australia So what does all this mean for Australia? There are three general points that I would like to make. The first is that global monetary developments are having a significant effect on the configuration of Australian exchange rates and interest rates, and thus on our asset prices. The monetary stimulus abroad has tended to put downward pressure on the value of the currencies concerned. Conversely, it has put upward pressure on the value of other currencies where the need for monetary stimulus has been less, including the Australian dollar. While movements in the value of our own currency remain heavily influenced by changes in commodity prices, the upward pressure on the Australian dollar from developments abroad has complicated the transition of the economy following the mining investment boom. With our exchange rate higher than it otherwise would have been, domestic demand has been a bit weaker. The Reserve Bank Board has responded to a softer economic outlook by having interest rates lower than otherwise. The easier monetary policy in Australia has supported the domestic economy. It has done this partly by offsetting some of the upward pressure on our currency from developments abroad, although the scale of global monetary stimulus means that our exchange rate remains relatively high given the state of our overall economy. The end result here is that global developments have left us with a higher exchange rate and lower interest rates than would otherwise have been the case. We may not like this configuration, but developments abroad give us little choice. The lower interest rates have boosted domestic asset prices, with both property and equity prices recording strong gains recently (Graph 8). The low interest rates globally have also worked to push up Australian asset prices. Overseas investors, faced with very low returns, have looked elsewhere around the world for higher-yielding assets. Some of these assets are in Australia and so we have seen significant inflows into some types of investment. One example of this is commercial property, where foreign investors have been attracted by the historically high yields. The higher asset prices are helping to support the economy, although they need to be watched carefully, particularly where they are accompanied by higher borrowing. BIS central bankers’ speeches The second general point that I would like to make is that the same factors that are affecting the transmission of monetary policy globally are also evident in Australia, although to a lesser extent. In common with households in a number of other countries, Australian households increased their borrowing over the decade or so to the mid 2000s as they adjusted to lower nominal interest rates and greater access to finance. During this period, the saving rate fell and indebtedness increased (Graph 9). But this adjustment is now complete. Over recent years many more households have focused on paying down their debts, rather than borrowing more, and the saving rate has increased. In the earlier period, the level of interest rates that we have today would have caused a large boom in borrowing, but this has not occurred. One area where this change in behaviour is apparent is in the household sector’s injection of equity into the housing stock (Graph 10). In the early 2000s when property prices were increasing strongly, many households used their newfound wealth to withdraw equity and enjoy higher levels of consumption. Again, this is not occurring on this occasion and this is changing the way that monetary policy affects the economy. A related part of the transmission mechanism that may be changing is the so-called cashflow channel. One of the ways that lower interest rates help boost spending is by improving the overall cash flow of the household sector. Since household borrowing exceeds household deposits, a cut in interest rates puts more money in the aggregate household budget. However, there are large differences across households. When interest rates go down borrowers pay less interest and so are better off. But savers receive less interest income and so are worse off. How these two different groups respond determines how powerful this cash-flow channel is. While it is not possible to be definitive, there are reasonable grounds to believe that the behaviour of both borrowers and savers might have changed a little. Many borrowers have responded to the lower interest rates of recent years by paying off their loan a little faster, rather than increasing their spending. This is evident in the data on total mortgage repayments and scheduled repayments (Graph 11). Conversely, it seems likely that those relying on interest income have reduced their spending by more than would previously have been the case. Certainly, the many letters we have been receiving at the Bank recently would suggest this. Unfortunately, one of the consequences of a world in which many more people want to save than to invest is that the return to saving falls, particularly on savings held in low-risk assets such as bank deposits. One other change to the global monetary transmission mechanism that has echoes in Australia is the behaviour of wages. As in many other countries, wage growth in Australia has been quite subdued and lower than would be suggested by most of our standard models. The latest reading of the wage price index shows an annual increase of 2½ per cent and the earnings per hour measure from the national accounts is lower still (Graph 12). This low level of wage growth is contributing to quite low rates of inflation in a range of service industries. Increased job uncertainty is likely to be one of the factors here, with consumer surveys showing high levels of concern about future unemployment. The third general point is that despite the transmission mechanism looking somewhat different, monetary policy in Australia is still working and it is helping to support the Australian economy. The area where this is most obvious is in housing construction, where there has been a substantial lift. This part of the transmission mechanism appears to be operating pretty much as normal, with the increase in activity over the past 1½ years being in line with our internal forecasts made in the second half of 2013 when the cash rate was first set at 2½ per cent. This increased activity is boosting employment in the sector and having flow-through effects to spending on homewares and related items. BIS central bankers’ speeches The exchange rate channel of monetary policy is also working. There are some signs that the depreciation of the Australian dollar is boosting domestic activity, with net exports of services increasing strongly. Also, in our liaison program a number of businesses have reported that they see the lower exchange rate as opening up new opportunities. In time, we should see the effect of this on domestic production and spending. Monetary policy is, of course, also working through the other channels that I discussed earlier, even if the effects are somewhat different from those in the past. So, overall, monetary policy is continuing to play an important role in supporting demand in the Australian economy. At its February meeting, the Reserve Bank Board decided that it was appropriate to provide some additional support. This was not because things had turned for the worse, but rather because of the lack of compelling signs that economic growth was picking up as was earlier expected. No doubt, the factors that I have talked about today go some way to explaining why this has turned out to be the case. At its meeting on Tuesday this week, the Board maintained the cash rate at 2¼ per cent, but noted that further easing may be appropriate over the period ahead. Finally, stepping back from the short term, the low interest rates we are seeing globally and in Australia are a direct consequence of an elevated appetite for saving and a muted appetite for real investment in many economies. Monetary policy globally has responded to this reality in a way that a decade or so ago would have hardly seemed imaginable. In doing so it has helped the global economy through a very difficult period. But, at the end of the day, the solution to the problems caused by the disconnect between the desire to save and the desire to invest cannot lie with monetary policy. Instead, it lies in measures to improve the investment environment so that once again there is strong productive demand for the use of our societies’ savings. Thank you and I would be happy to answer any questions you might have. BIS central bankers’ speeches Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches Graph 5 Graph 6 BIS central bankers’ speeches Graph 7 Graph 8 BIS central bankers’ speeches Graph 9 Graph 10 BIS central bankers’ speeches Graph 11 Graph 12 BIS central bankers’ speeches | reserve bank of australia | 2,015 | 3 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the National RSL Clubs Conference, Hobart, 11 March 2015. | Christopher Kent: Australian economic growth – the how, what and where Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the National RSL Clubs Conference, Hobart, 11 March 2015. * * * I thank Kathryn Davis, David Jacobs and James Wang for excellent assistance in preparing these remarks. Accompanying graphs and the table can be found at the end of the speech. Introduction I’d like to thank the Board and members of the RSL & Services Clubs Association for their invitation to speak here. I want to consider three closely related questions I am often asked: 1. How can the Australian economy become more productive? 2. What will help generate additional growth (in demand) needed to boost employment? 3. Where is that growth going to come from? In particular, which industries will have the profitable opportunities that will lead to more employment and drive investment? It is hardly surprising that Australians are interested in these questions given the rise in the unemployment rate and sub-trend growth of the economy over the past couple of years. How to be more productive? From the middle of the previous decade, Australia enjoyed a sharp run-up in the prices of our key commodity exports. This led to an unprecedented boom in mining investment. The benefits were spread beyond the narrow confines of the mining industry in numerous ways, with strong growth in employment and wages across a range of industries around the country.1 But now that commodity prices and mining investment have turned down, it is natural to ask: how are we going to sustain and build on our standard of living over the longer term? This boils down to two essential elements. We can work more (i.e. raise our labour force participation). We can also work more efficiently. In other words, we can boost our (labour) productivity, which is the source of sustainable gains in wages and profits (in the absence of a resurgence in commodity prices).2 I’ve spoken elsewhere about participation, so let me focus here on productivity.3 There are a number of sources of growth in labour productivity (i.e. output per hour worked): • technological progress, which supports new business processes and new production techniques as well as more efficient use of productive resources. In other words, an expansion of the technological, or productive frontier See, for example, Bishop J and V Rayner (2013), “Industry Dimensions of the Resource Boom: “An InputOutput Analysis”, RBA Research Discussion Paper No 2013–02. While I have couched this in terms of labour productivity, that in turn will depend on both multifactor productivity and capital deepening. Kent C (2014), “Cyclical and Structural Changes in the Labour Market”, Address on Labour Market Developments, hosted by The Wall Street Journal, Sydney, 16 June. BIS central bankers’ speeches • additional physical capital, both private and public, some of which may embody new technologies • more human capital (via education and training). These things have a somewhat formulaic air to them. They suggest that we just need the right combination of inputs so as to produce goods and services as efficiently as possible. But for that to lead to sustainable growth of incomes – of wages and profits – we need to make sure that the goods and services produced are those that people want at a price they are willing to pay. Also, we need to fund investment from domestic or foreign sources of savings, which are provided with the expectation of a reasonable return. A market-based economy can achieve these things with the help of competitive and flexible labour and product markets.4 These provide the price and wage signals that encourage labour and capital to move into profitable opportunities and out of unprofitable ones. Competitive markets also encourage companies to seek out efficiency gains and pursue innovations. Developing new products or processes and taking advantage of scientific progress are key drivers of long-term growth. It helps too for those markets to be supported by a robust institutional framework, such as: the rule of law; effective regulation and oversight of parts of the economy, including to ensure the soundness of the financial system; and institutions to oversee the efficient provision of public services and infrastructure, and encourage prudent management of fiscal and monetary affairs. Productivity growth was especially strong across many countries, including Australia, over the decade starting in the mid 1990s (Graph 1). There may have been some common sources to this strong growth. An obvious candidate is technological progress.5 In the case of Australia, and a number of other countries, a range of earlier economic reforms may also have played a role. These included a broad-based deregulation of financial, product and labour markets, further liberalisation of international trade and a program of corporatisation and privatisation of public enterprises.6 While these things don’t push out the technological frontier, they provide an environment that encourages and enables us to get closer to that frontier. Following this period, there was time from the mid 2000s during which productivity growth was considerably slower than its longer-term average. This slowdown was also common to a number of economies.7 However, productivity growth has picked up in Australia over more recent years. Some of this reflects the move from the investment to the production phase of the mining boom, which has seen a strong rise in output combined with a reduction in employment in resource-related activity. But the pick-up in productivity growth is broadly based across other sectors of the economy. This may, in part, reflect the response of businesses to rising competitive pressures following the period when the exchange rate had risen to very high levels, growth For cross-country evidence on the links between reforms to product and labour markets and productivity, see Kent C and J Simon (2007), “Productivity Growth: The Effect of Market Regulations”, RBA Research Discussion Paper No 2007–04. See Gruen D (2001), “Australia’s Strong Productivity Growth: Will it be Sustained?”, Address to CEDA/Telstra Economic and Political Overview, Sydney, 2 February; Connolly E and L Gustafsson (2013), “Australian Productivity Growth: Trends and Determinants”, Australian Economic Review, 46(4), pp 473–482; and D’Arcy P and L Gustafsson (2012), “Australia’s Productivity Performance and Real Incomes”, RBA Bulletin, June, pp 23–35. Gruen D and S Shrestha (eds) (2000), The Australian Economy in the 1990s, Proceedings of a Conference, Reserve Bank of Australia, Sydney. Connolly E and L Gustafsson (2013) and D’Arcy P and L Gustafsson (2012). BIS central bankers’ speeches of non-mining activity had been relatively weak and wage growth relatively strong. Responding to those pressures is not easy. A common theme from the Bank’s liaison program in recent years has been the heightened focus on reducing costs and improving productivity in response to the subdued growth in demand. In more extreme cases, however, it involves businesses that are not sufficiently productive going out of business and workers losing their jobs. What more could be done to secure strong productivity growth? As others have noted before me, the experts at the Productivity Commission have put together a “list” of what could be done.8 The list describes how improvements to incentives, capabilities and flexibility could enhance productivity. Again, the idea is not that these things can push out the technological frontier, but they can help us get closer to it. Recommendations to improve incentives largely focus on promoting competition, such as further reducing barriers that inhibit international trade or new entrants to markets. Policies on capabilities focus on the development of human capital, improving infrastructure and government services as well as the institutions for creating and transmitting knowledge (academic institutions and their links with the business community, for instance). The third part of the list deals with providing a more flexible regulatory environment and reducing unnecessary “red tape”. Any one policy will be helpful by itself, but it is likely that the combined effect will be greater than the sum of each of the parts. This discussion has focused on how economies can support growth over the longer term. You will note, however, that I haven’t said much about the role of monetary policy. While monetary policy can help to ensure low and stable inflation, and contribute to macroeconomic stability, it cannot influence the longer-term determinants of growth. Even so, monetary policy has an important role in influencing economic activity over the course of the business cycle, which is the subject of the next question. What will help generate additional growth in demand over the next couple of years? Since about mid 2012, Australia’s GDP growth has been a bit below trend and so the unemployment rate has been rising gradually (Graph 2).9 The Bank’s recent update to its forecasts has pushed out the time at which we see GDP growth picking up from its current sub-trend pace. It is not that economic growth has weakened of late. But there is little to suggest that it will increase in the near term. This implies that the unemployment rate will rise for a bit longer and peak a bit higher than previously expected. The question then is what is it that will generate an improvement in the rate of economic growth and lead to a decline in unemployment? What are the triggers for such a revival? Part of the answer is that the very low level of interest rates is expected to sustain strong activity in the housing market and support household wealth. This will provide some support for consumption, although the response of consumption to low rates may be somewhat less and work in different ways from previous episodes, in part because of the higher levels of For more detail, see Banks G (2012), “Productivity Policies: The “To Do” List”, Economic and Social Outlook Conference, “Securing the Future”, Melbourne, 1 November. The decline in the unemployment rate following the run-up in the midst of the global financial crisis is interesting given that average GDP growth over that period was not especially strong (at 2¾ per cent per annum). The decline in the unemployment rate may, in part, reflect an unwinding of the earlier rise in unemployment, which was relatively large compared with the early 2000s slowdown (for which average GDP growth was similar). It may have been that businesses anticipated a more significant slowdown in demand during the global financial crisis than occurred, leading the unemployment rate to “overshoot”, with a correction thereafter. BIS central bankers’ speeches household indebtedness now.10 Low interest rates also work by raising overall cash flows for the household sector (since households are borrowers in net terms) and by encouraging households to bring forward some spending and lower their saving rate a little further. Looking back over the past year we can see the effect of low interest rates at work. Dwelling investment has grown strongly and made a contribution to demand across all the states (Graph 3). Consumption growth has picked up a bit, particularly in New South Wales, but it remains a bit below average for the nation as a whole. Consumption growth is weakest in Queensland and Western Australia, which are dealing with the direct effect of the decline in mining investment. Business investment is making a positive contribution to growth in the other states. Meanwhile, in line with fiscal consolidation at state and federal levels, public demand has made no contribution to growth for the country as a whole, but the contribution is mixed across the different states. In time, a pick-up in household demand should encourage businesses (outside of the resources sector) to increase employment and undertake more investment. When that occurs, businesses will make more use of funding that is currently readily available at low cost. Also, exports, especially of resources – most notably liquefied natural gas (LNG) – are expected to continue to contribute significantly to growth, while declining mining investment and, to a lesser extent, fiscal consolidation are likely to weigh on growth over the next couple of years. It’s tempting to think that economies are well served by being directed or guided in a way that will produce better outcomes. There is some truth to that. Monetary policy is certainly playing an important role, but it guides things rather imprecisely, with the relatively blunt tool of the overnight cash rate. Other means of adjustment Economies are responsive in many other ways that don’t require the active input of policymakers. The so-called “invisible hand” of markets can provide the incentives for producers and consumers to alter their behaviours via a range of price signals. The exchange rate provides one such signal. The earlier substantial appreciation of the Australian dollar in response to very high prices for our commodity exports was a signal for labour and capital to move into the resources sector.11 But, for a time, the Australian dollar stayed high even after mining investment and commodity prices began to turn down. That meant that it was not playing the usual role of helping to rebalance growth towards other parts of the economy. However, the Australian dollar has depreciated by nearly 20 per cent (on a trade-weighted basis) since its peak in mid 2013 and is starting to play a role in helping the economy to adjust. Australians and foreigners will direct more of their spending to Australian produced goods and services (such as tourism and education) as they become relatively cheaper compared with the alternatives available offshore. Along the same lines, the depreciation has lowered the level of Australian wages when measured in foreign currency terms; since April 2013, they are 30 per cent lower in US dollar terms. While the depreciation seen to date will be helpful, our assessment is that our exchange rate remains relatively high given the state of our overall economy. Lowe P (2015), “Low Inflation in a World of Monetary Stimulus”, Address to the Goldman Sachs Annual Global Macro Economic Conference, Sydney, 5 March. Plumb M, C Kent and J Bishop (2013), “Implications for the Australian Economy of Strong Growth in Asia”, RBA Research Discussion Paper No 2013–03. BIS central bankers’ speeches A change in the growth of wages (in Australian dollar terms) is also an important source of adjustment. Just as wage growth picked up when conditions in the economy were stronger, the growth rate of wages has declined substantially since 2012 (Graph 4). The lower growth of wages works to depress the growth of incomes for those in employment. At the same time, however, lower wage growth allows for more employment than would otherwise be the case, which works to support the growth of total labour incomes. In a similar vein, the pick-up in productivity growth over recent years means that the cost of obtaining the labour required to produce a unit of output (the unit labour cost) has not changed for three years. In summary, the economy is currently operating somewhat below its productive capacity. The forecast is for a gradual increase in the growth of demand and employment, and eventually a rise in non-mining business investment, supported by the very low level of interest rates. The lower exchange rate will offer some support to demand for Australian produced goods and services. Adjustments are also occurring along other dimensions, such as gains in productivity and slower growth of wages, both of which will help place the economy on a stronger footing. So that is what I think can help, in time, to generate some more growth. It is based on a macroeconomic perspective, and draws on knowledge of the history of business cycles. It’s only natural though to want more tangible evidence regarding the prospects for growth. That is, where is the growth going to come from more specifically? Where is the growth going to come from? In some ways this is the hardest of the three questions. It is difficult to know what new products and companies will come along, and which products and companies they might displace. And while no doubt there will be further technological progress and innovation, it is hard to predict how this will affect specific industries, especially for those not yet in existence! Nevertheless, we can say a few things about the general forces and trends that are likely to be with us for a time. One such trend is the increasing importance of household and business services in the economy. Over the past 30 years, households have increased the share of their spending devoted to services, from about 53 to 65 per cent of their total consumption (Table 1). Health and education account for a large part of that. Households are also spending a larger share of their growing incomes on recreation and leisure services, as well as communication and financial services. The shift in spending away from goods reflects, in part, the fall in the relative prices of goods. In turn, that reflects stronger productivity growth for goods relative to services as well as the development of lower-cost manufacturers in emerging economies. That is, the world has become much better at producing goods. Mirroring these trends in consumption and production, the share of employment in household services has increased from 25 to 33 per cent over the past 30 years. This includes employment in accommodation and food, arts and recreation, education and training, and health care and social assistance. These are all things we want and need more of as our appetites for goods becomes more easily satisfied. Business services have increased substantially as a share of output and employment. In part this is because it has become increasingly cost-effective for businesses to outsource a lot of their “non-core” functions to other more specialised industries. For example, accountants that used to work for a manufacturing firm may now be in the “business services industry” helping out a wide range of different companies. Resource production and exports are likely to continue to grow strongly for the next few years as the new LNG facilities ramp-up production. While many people across a wide range of industries helped to build those facilities, a much smaller workforce is required once they enter into production. Mining more generally is likely to continue to account for a relatively small share of total employment. BIS central bankers’ speeches Manufacturing output has increased over the past few decades as a whole, but not as much as output from other industries. This is common to most developed economies, reflecting the increased demand for services and the emergence of lower-cost manufacturers in emerging economies. The high level of the Australian dollar has also weighed on manufacturing over recent years.12 Those manufacturers with more exposure to the construction industry (including in mining) and focused on more complex, highly skilled techniques have tended to fare better than those exposed more to the pressures of international competition from emerging markets. The depreciation of the Australian dollar over the past year or so is expected to support expansion of industries in the traded sector. This will benefit both goods and service industries exposed to trade. Exports of services, which include education and tourism as well as business services, were worth about $60 billion in 2014, and at current prices were a touch higher than iron ore exports at the end of last year (Graph 5).13 Most of the growth in services exports is attributable to rapidly growing economies in the Asian region. These service industries should benefit from further strong growth of demand from that source, with many more households in Asia gaining a foothold in the middle class. While Australia has many strengths in these service industries, our comparative advantage here is perhaps not as obvious as it is in mining and agriculture, which benefit from our substantial endowments of natural resources. This means that we will need to continue to work hard to maintain competitiveness in these global markets. Conclusions The Australian economy has good prospects for growth over the longer term. Among other things, we have the advantage of a well-educated workforce, strong population growth and a robust institutional framework. Also, we are closer to a rapidly developing part of the world than we are to many slower growing developed economies. We have benefited too from earlier reforms. Among other things, this has left us with more flexible and competitive product and labour markets than we had in the past and helped us to get closer to the technological frontier. However, other countries will continue to pursue reforms and we can’t rest on our laurels. The Bank’s central forecast for economic activity is for growth to gradually pick up over the course of the next couple of years. Monetary policy has been and will continue to play its part in this regard. The depreciation of the exchange rate seen to date is helpful. And we shouldn’t forget that there are other sources of adjustment, including the pick-up in productivity growth over recent years. However, as we’ve emphasised regularly, forecasting is difficult, there are many uncertainties and better growth is not guaranteed. It is also difficult to know exactly where growth will occur. The very low level of interest rates suggests that the housing market is likely to remain strong. We will probably see a continuation of trends such as the growing importance of the services sector in our economy, which is relatively intensive in terms of employment. Resource production and exports are less employment intensive, but the significant investment in that sector will continue to bear fruit for a long time. Finally, a lower exchange rate will provide support for demand for the output of the wide range of firms operating in the tradable sector. See Downes P, K Hanslow and P Tulip (2014), “The Effect of the Mining Boom on the Australian Economy”, RBA Research Discussion Paper 2014–08. For a discussion of tourism exports, see Dobson C and K Hooper (forthcoming), “Insights from the Australian Tourism Industry”, RBA Bulletin, March. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches | reserve bank of australia | 2,015 | 3 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the KangaNews Debt Capital Markets Summit 2015, Sydney, 16 March 2015. | Guy Debelle: Global and domestic influences on the Australian bond market Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the KangaNews Debt Capital Markets Summit 2015, Sydney, 16 March 2015. * * * I would like to thank Emma Doherty, Suchita Mathur and John Boulter for their assistance in preparing these remarks. Accompanying graphs can be found at the end of the speech. Today I will talk about some of the global and domestic factors that are influencing conditions in the Australian bond market. I’ll start with a discussion on the decline in global bond yields that we’ve seen over the past year or so before turning to focus on how these and other developments have played out in the Australian bond market. I will finish with some recent and prospective regulatory developments affecting the local market. Global influences At the beginning of 2014, the 10-year Treasury yield in the US was around 3 per cent. At that yield, investors were getting some compensation for duration risk in the form of a term premium; that is, some compensation for uncertainty about the future path of US monetary policy. However, over the course of 2014 the yield declined steadily, reaching a low of 1.64 per cent in early 2015, close to the historical lows reached in July 2012. With a yield of 1.64, investors were getting little or no compensation for term risk or the risk of inflation. Indeed, one could argue that the term premium was even negative. There was no meaningful compensation for uncertainty about the path of US monetary policy or inflation. This decline in US yields was also evident in nearly all advanced economies and occurred despite some notable variations across countries at the shorter end of the curve (Graph 1). Over recent months, it has looked more like yields in Germany driving those in the US and elsewhere rather than the traditional relationship of US yields driving those in other markets. In recent weeks, some of the decline in yields has been unwound in the US and a few other economies such as the UK, but 10-year yields in the euro area have fallen further to reach new historic lows, with the 10-year yield in Germany now noticeably below that in Japan. As has been remarked on frequently, the 10-year yields in Spain and Ireland are currently below that in the US. At the shorter end of the yield curve, expectations for future monetary policy settings are an important driver. There has been a notable divergence in expectations for the path of monetary policy in major developed economies since the middle of 2013. In the US, the Fed gradually slowed the pace of its asset purchases from January 2014 and ceased them altogether in October. More recently, it has indicated that it is getting closer to raising the level of the federal funds rate target for the first time in nearly a decade. In contrast, over the same period the European Central Bank (ECB) has moved to further loosen monetary policy settings in the euro area, culminating with the announcement in early 2015 of a sovereign bond purchase program. Several European countries that are not members of the euro area have lowered the interest rate paid on deposits with the central bank to negative territory, a move that the ECB made in September 2014. Meanwhile, the Bank of Japan (BoJ) has continued its quantitative easing program, increasing the scale of its asset purchases in late October. The influence of this divergence in monetary policy on the relevant sovereign bond markets is evident in the movements in yields on 2-year government bonds over the past 18 months BIS central bankers’ speeches (Graph 2). In particular, 2-year US Treasury yields have risen a little since late 2013 while 2-year German government bond yields have declined steadily and turned negative. At the longer end of the curve, as I noted earlier, the trajectory of sovereign yields has been more uniform, with the implied yield on a 5-year bond starting in 5 years’ time (the 5-year, 5-year-forward yield) falling consistently throughout 2014. The uniformity of these movements suggests that global factors have played a role. While it is straightforward to come up with explanations for the direction of movement in yields, I do not find any of them compelling in explaining the size of the downward movement. One possible contributor to the decline in yields has been concerns about the global growth outlook, but expectations for global growth over the medium term haven’t changed all that much. Secular stagnation is also another popular explanation as lower real growth implies lower real yields (although I am more optimistic about the world than the one this theory implies). Yields may also have been influenced by the prospective reduced supply of government bonds: the gradual improvement in governments’ fiscal positions is reducing funding needs and government bond issuance. At the same time, the quantitative easing programs of the ECB and the BoJ have also worked to increase actual and anticipated demand for bonds, and there is increased demand from banks to hold sovereign debt to meet liquidity requirements. While the Fed is no longer making net purchases, it has indicated that it will keep the stock of its asset holdings constant for some time by reinvesting maturing holdings in US Treasuries. One remarkable outcome is that a large proportion of developed countries’ government bonds are now trading at negative yields in secondary markets. Two-thirds of the German and Swiss government bonds on issue are currently trading at negative yields, while yields on bonds of up to five years in maturity from the Japanese and a variety of European governments have recently traded at negative yields. Five-year, 5-year-forward real yields have generally followed the trajectory of nominal yields, but have declined by less over 2014. With larger declines in nominal yields than real yields, estimated breakeven inflation rates – the spread between nominal and inflation-linked bond yields – have declined (Graph 3). (This calculation is complicated somewhat by the relatively lower liquidity in indexed bond markets.) One interpretation of this is that expectations for inflation have fallen considerably. The sharp decline in oil prices has certainly reduced near-term inflation expectations as most advanced economies are net oil importers. But this would only account for a decline in inflation expectations in the short term. A substantial decline in medium-term inflation expectations is more difficult to explain. Survey-based inflation expectations from market economists and consumers do not appear to have declined substantially over the same period. It is also worth noting that the decline in longer-run inflation expectations over the past six months is not a universal phenomenon – Australian breakeven rates were broadly flat over the second half of 2014 (and consistent with the RBA’s inflation target). Finally, one potential explanation that I have only briefly discussed above is that yields are being held down by a shortage of risk-free assets as demand for these assets has increased.1 I find this explanation of increased demand for such assets in the face of slower growth in the supply to be the most plausible. But even so, term premia are unusually compressed and there is little overall compensation for risk. Zoltan Pozsar has some interesting work on this; see Pozsar Z (2015), “A Macro View of Shadow Banking: Levered Betas and Wholesale Funding in the Context of Secular Stagnation”, mimeo, 31 January, available at <http://ineteconomics.org/sites/inet.civicactions.net/files/Macro_View_Final.XcxMB4_.pdf>. Ricardo Caballero has also written on this topic; see Caballero R (2013), “The Shortage of Safe Assets: Macroeconomic Policy Implications”, presentation at the Bank of England, May, available at <http://www.bankofengland.co.uk/ research/Documents/ccbs/cew2013/presentation_caballero.pdf>. BIS central bankers’ speeches Australian Government Bond Market Yields on Australian Government bonds have been affected by these international factors over recent months as well as some domestic influences. At the shorter end, the February reduction in the cash rate target and associated repricing of market expectations for future monetary policy have contributed to a decline in yields. At the longer end, there has been a tendency for yields to follow developments in global markets. While the strong historical correlation between yields on long-term Australian and US government bonds has been evident, the spread between 10-year yields has narrowed considerably, declining from 100 basis points in the middle of last year to be as low as 40 basis points. The net outcome of these developments has seen yields on Australian 10-year Commonwealth Government securities (CGS) decline to their lowest level since Federation with an all-time low of 2.28 per cent being recorded in February (Graph 4). These declines in CGS yields over recent years – and similar declines in yields on state government bonds (“semis”) – have occurred notwithstanding an increase in the supply of CGS and semis on issue. But the stock of debt on issue remains considerably less as a share of GDP than nearly all other jurisdictions (Graph 5). BIS central bankers’ speeches The vast majority of the post-crisis CGS issuance has been purchased by non-residents attracted to the Australian Government’s AAA credit rating and favourable level of yields relative to other highly rated sovereign issuers. The six-fold increase in non-residents’ holdings of CGS since late 2007 took non-residents’ ownership of the outstanding stock of CGS to just under 80 per cent in 2010, although this share has declined a little recently (Graph 6). The recent decline is not because of any net selling, but rather because buying has not quite kept pace with recent issuance. The increased foreign holdings of government debt have been reflected in a notable change in the composition of Australia’s foreign liabilities (Graph 7). The stock of net foreign liabilities has remained steady at around 55 per cent of GDP for the past decade. But over the past five years, foreign holdings of Australian government debt have risen to around 20 per cent of GDP, with a broadly offsetting decline in foreign holdings of Australian bank debt as a share of GDP. Turning to developments in the semis market, yields on semis have fallen by more than those on CGS, such that secondary market spreads have fallen to around 30 basis points. This is around the lowest spread seen since the early 2000s and semi yields are at historical lows. State governments are able to borrow on average at rates under 3 per cent (Graph 8). In terms of ownership, since 2007 there has been a marked increase in the share held by banks in Australia. This is a consequence of banks’ desire to hold more high-quality liquid assets (HQLA) in the aftermath of the global financial crisis and, more recently, the Liquidity Coverage Ratio (LCR) prudential requirements that came into effect in Australia at the beginning of 2015. APRA has determined that the Australian banking system needs to hold around $410 billion of HQLA in 2015. Of this amount, and based on RBA advice, up to $175 billion could be met through holding CGS and semis. The Bank’s assessment is that larger holdings by Australian banks could impair liquidity of these securities, undermining the purpose of the LCR. The introduction of the LCR has proceeded smoothly, but of course APRA and the RBA will continue to monitor developments in markets to ensure that liquidity conditions remain appropriate. The increased demand from banks for semis is having a noticeable impact on the type of debt securities being issued by the states (Graph 9). In line with the banks’ preference for floating-rate debt – which can be better matched to banks’ floating-rate liabilities – the share of floating-rate semis in recent years has increased. Consequently, the share of floating-rate notes in the outstanding stock of semis has increased from 2 per cent at the end of 2012 to around 10 per cent at present. Similarly, the preference of banks for shorter term debt has led to a decline in the average tenor of semis outstanding. Regulatory developments I will finish by discussing the effect of some recent regulatory changes in the local fixed income market. One global development that has garnered a large amount of comment of late is the effect of reduced market-making capacity in fixed income.2 The Bank for International Settlements (BIS) Committee on the Global Financial System (CGFS), of which I am a member, issued a report on this topic late last year.3 That report documents the intended effect of regulation in Debelle G (2014), “Volatility and Market Pricing”, Speech to Citi’s 6th Annual Australian and New Zealand Investment Conference, Sydney, 14 October. CGFS (2014), “Market-making and Proprietary Trading: Industry Trends, Drivers and Policy Implications”, CGFS Papers No 52. Available at <http://www.bis.org/publ/cgfs52.htm>. Jon Cheshire, who was a member of the working group, has an article in the March RBA Bulletin discussing this issue from an Australian perspective. BIS central bankers’ speeches bringing about this reduction. There is a debate as to whether the reduction has gone too far, but the fact that market-making activity is lower than it was pre-crisis is a desirable outcome given liquidity risk was under-priced pre-crisis. Rather than describing it as a reduction in market-making, I think it is more useful to think of it as a reduction in the risk-absorption capacity of intermediaries. Their ability to warehouse portfolio adjustments of asset managers is curtailed. In the past, asset managers were dealing bilaterally with individual trading desks that each had their own limit. Now these limits are applied holistically across the trading desks so that selling one part of a portfolio to one desk will reduce the capacity to sell another part of the portfolio to another desk in the same institution. Asset managers need to take account of these changes in market dynamics in thinking about how they adjust their portfolios. Transactions costs are higher and, in particular, liquidity costs are higher. I am not sure that all market participants have fully appreciated this yet and are fully cognisant of the impact of the post-crisis changes. The second development to note is in the asset-backed security space. As many of you know, as of 30 June this year, the Bank will introduce mandatory reporting requirements for repo-eligible asset-backed securities (ABS). The Bank continues to work with the industry to ensure the timely implementation of these requirements. The required information, which must also be made available to permitted users, will promote greater transparency in the market, supporting investor confidence in these assets. These requirements will also provide the Bank with standardised and detailed data on ABS, which are a major part of the collateral eligible to be used under the CLF. In preparation for the introduction of these reporting requirements and to facilitate industry readiness, the reporting system for securitisations was made available for industry testing in November 2014, with voluntary reporting accepted from 31 December 2014. The Bank is currently working with a number of institutions undertaking test submissions, with some institutions expecting to commence regular reporting shortly. The industry is strongly encouraged to undertake testing early to ensure readiness for the commencement of mandatory reporting on 30 June 2015. The third development is the proposed changes to the settlement convention to T+2 for overthe-counter (OTC) transactions in domestic fixed income securities. The Bank strongly encouraged this initiative. The current standard of T+3 settlement in the Australian market compares unfavourably with many other jurisdictions that have already progressed to shorter settlement cycles for OTC transactions in their domestic fixed income markets. A shorter settlement cycle will reduce the risks associated with settlement, in particular, counterparty risk. Market makers in OTC fixed income securities may particularly benefit from the reduced period of counterparty exposure, as any given trade will count towards internal credit limits for a shorter period of time. This could boost market turnover and trading capacity for participants. Further, moving to T+2 is likely to encourage straight-through processing, which could reduce the risk of an operational issue affecting the settlement of OTC fixed income securities. Ideally, this would be implemented by the end of 2015. Finally, a few words on interest rate benchmarks. The RBA, together with ASIC, is working with the industry through AFMA to develop a robust risk-free interest rate benchmark in the local market, likely based on overnight indexed swap (OIS) rates. Once this is operational, this will help engender a movement of products towards referencing a risk-free benchmark rather than a credit benchmark such as bank bill swap (BBSW) rates.4 We expect to see progress on this in the coming months. This is part of a global initiative that is part of the FSB work agenda. BIS central bankers’ speeches Conclusion To conclude, there are a large number of moving parts in fixed income at the moment. A number of international and domestic factors are having an important influence on Australian bond markets. The low levels of yields globally and domestically are difficult to explain, most notably the low level of term premia. The most plausible explanation relates to a shortage of “risk-free” assets although with term premia so low, it’s not clear how risk-free they actually are. At the same time as grappling with these developments, investors need to be aware of the changed market dynamics and factor the higher transactions costs in fixed income, and particularly the higher cost of liquidity provision, into their decision-making. BIS central bankers’ speeches Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches Graph 5 Graph 6 BIS central bankers’ speeches Graph 7 Graph 8 BIS central bankers’ speeches Graph 9 BIS central bankers’ speeches | reserve bank of australia | 2,015 | 3 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce in Australia (AMCHAM), Melbourne, 20 March 2015. | Glenn Stevens: Remarks to the American Chamber of Commerce in Australia (AMCHAM) Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Chamber of Commerce in Australia (AMCHAM), Melbourne, 20 March 2015. * * * Thank you for the invitation to join you today. In an audience of business leaders exposed to the American and Australian business scenes, I might be expected to attempt some comparisons of the two economies. So I offer the following snapshot. • In America, growth has improved over the past year, having been much slower than policy makers would have liked for quite a few years, after a very deep recession in 2008–09. Real GDP per head is 2¾ per cent above its previous peak in December 2007. • In Australia the economy is growing, but has been somewhat slower than we would have liked for a while. We haven’t had a deep downturn for more than twenty years. Real GDP per head is about 5½ per cent higher than in December 2007. • In America, the unemployment rate peaked at 10 per cent in October 2009 and is now at 5½ per cent. The average rate in the new century to date (ie since 2000) is 6½ per cent. • In Australia the unemployment rate in October 2009 was about 5½ per cent. It fell, then gradually rose again to be 6¼ per cent now. The average in the new century to date is 5½ per cent. • In America, inflation is low and asset values have been rising. Interest rates are extremely low, but the central bank is talking about raising them. • In Australia, inflation is low and asset values have been rising. Interest rates are very low, and the central bank has talked about lowering them further. • In America, international competitiveness is declining due to the rising US dollar. • In Australia, international competitiveness is improving, due to the declining Australian dollar. • In America, there is political partisanship across a range of issues, and budget stalemate. • In Australia, there is political partisanship across a range of issues and, over the past year, budget stalemate. The result? American businesses and households seem to be getting more optimistic about the future. But Australian businesses and households seem to be getting less optimistic about the future. It would be an interesting lunch conversation to talk about how all those facts lead to the two differing conclusions about the future. Admittedly, the global backdrop in some respects is less supportive to Australia than it had been some years ago. Our terms of trade are falling. They have been doing so for about 3½ years. It had always been understood that this would occur, even if we were not very accurate in predicting its timing (we predicted it way too early) or its extent: some key resource prices initially fell a little more slowly, but more recently a good deal more quickly, than either official or private consensus forecasts had assumed. Nonetheless, the actual BIS central bankers’ speeches event has been getting much attention. The various ramifications – declining mining investment, the effects on incomes and government revenues – are the subject of daily news. In some other respects, not a lot has changed lately. China continues to grow in size and importance and to open up. Much was made of China “missing” its 2014 growth target, by one tenth of a percentage point. (Let us in Australia hope our target misses are all only of that size.) Much was also made of the lower target set for 2015, but this was always going to occur, and successive growth objectives are likely to get progressively lower over the years ahead. An economy as large as China is unlikely to sustain the sorts of growth rates seen in earlier years. No one grows at 10 per cent forever. Even growth a bit below this year’s objective would still be a considerable impetus to global demand and output. That said, the outworking of some of the excesses of the earlier period of rapid growth, especially the period just after the financial crisis of 2008, remains a work in progress and a source of risk. But in other ways, one could argue that the global backdrop has improved. As I have noted, the US economy – still the world’s largest and most innovative – has gained momentum over the past year, looking through the temporary ups and downs of the data. For all China’s great importance to Australia these days, a healthy US economy should not be underestimated as a driver of business thinking and as a trend-setter for financial markets. In addition, the fall in oil prices, which is mostly the result of more oil being available than used to be the case, is mainly a bullish development for the global economy in the short term, problems for producer states notwithstanding. It is a bonus for American consumers certainly. It is expected that the Federal Reserve will, some time this year, lift the federal funds rate accelerator off the floor. If that happens there will no doubt be some disruption, as always, and more so as it will be the first Fed tightening for nine years and the ECB will be easing policy at the same time. So there is likely to be some turbulence in asset and foreign exchange markets. On the whole, though, I think we should regard the Fed’s likely actions as a positive development. Fed policy is still likely to be quite expansionary for some time. The punch bowl isn’t being taken away, its contents are just being made a little less potent. While that is going on our own economy continues its adjustment to the end of the investment phase of the “mining boom”. The massive run-up in resources sector capital spending that was a natural response to earlier very high prices is reversing, causing a drag on demand. So we hope for other sources of demand to speed up to help make up the difference. Some of them are, though not as seamlessly as any of us would like. I’ve talked a lot about this before so I won’t labour the point. It is a major transition. We can hope to assist it, and the Reserve Bank is doing that, and will continue to lend what support it can, within the limits of its powers and consistent with its mandate. The decline in the exchange rate is assisting the transition (as it assisted in absorbing the earlier phase of the mining boom). But we have always said we cannot hope to fine-tune this transition, however much we may wish otherwise. Looking back at the history of such episodes, of which there have been a few over the past century or more, if we come through this terms of trade event with neither a major outbreak of inflation in the upswing nor a major crash in the downswing, even if we have a period of sub-average growth in the process, we will have done far, far better than in any previous event of this kind, let alone one of this magnitude. I still think that is the most likely outcome. Even so, the lower terms of trade mean that, all other things equal, the path of future incomes is not as high as it might have looked a few years ago. Even allowing for the fact that we all knew, intellectually, that at least part of the boom was not permanent, there is a human tendency to project what we see now (good or bad) into the future. Eventually reality intrudes and we have to re-evaluate. That has happened countless times before and will again, no doubt. It means that attention needs to be given to the things that help our economy work to deliver what we need even with a lower terms of trade. These were the sorts of things that made a BIS central bankers’ speeches difference before the mining boom. They are not my field of expertise. I can simply observe that things such as: • open, competitive markets; • education and skill building; • flexibility and adaptability; • quality public infrastructure; • strong public institutions, and pragmatic, balanced regulatory arrangements; and • rewards for entrepreneurial risk-taking are likely to give us the best chance for the kind of prosperity we seek. Public policy will have its own contribution in fostering such an environment, but it is businesses (large and small) and individuals making their own choices that will ultimately deliver whatever success we are capable of. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 3 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Australian Association luncheon, hosted by Goldman Sachs, New York City, 21 April 2015. | Glenn Stevens: The world economy and Australia Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the American Australian Association luncheon, hosted by Goldman Sachs, New York City, 21 April 2015. * * * I thank Elliott James for assistance in preparing these remarks. Thank you to the American Australian Association for affording me the opportunity to speak again in New York. Thank you also to Goldman Sachs for hosting the event. The world economy There are about as many indicators of the world economy as there are people studying it. My remarks will be fairly high-level, and since we have just had the IMF meetings, it seems appropriate to begin with the picture they present. The Fund’s latest publication estimates that output in the world economy grew by 3.4 per cent in 2014 (Graph 1). This is a bit shy of the long-run average of 3.7 per cent, and actually fractionally above the previous estimate in October. The projections are for a slight pick-up in 2015 and around average growth in 2016. These figures are broadly in line with the private sector consensus. Most of the recent growth has come from the emerging world. As a group, the emerging world grew by 4½ per cent in 2014. China grew by about 7½ per cent, more or less as the authorities intended. It will probably grow by a little less in 2015; the IMF is saying below 7 per cent. But given its size now, China growing at 6–7 per cent would still be a major contributor to global growth. Indeed, the current projections have China contributing about the same growth in global output in 2015 and 2016 as it did in recent years. Meanwhile, growth looks to have picked up in India but softened in some other emerging markets. Graph 1 In the major advanced economies, in contrast, growth has generally been below previous averages for quite a number of years. It has taken longer to recover than we had all hoped. There are, happily, some signs of improvement at present. Growth is slowly recovering in the euro area and has resumed in Japan. In the United States, notwithstanding some recent BIS central bankers’ speeches softer numbers, the economy looks to have pretty reasonable momentum. So it would appear that we are heading in the right direction. Unfortunately, that doesn’t mean the legacy of the 2008 crisis is yet behind us. From the vantage point of most central banks, the world could hardly, in some respects, look more unusual. Policy rates in the major advanced jurisdictions have been near zero for six years now. In fact, official deposit rates in the euro area and some other European countries are now negative. As it turns out, the “zero lower bound” wasn’t actually at zero. Central bank balance sheets in the three large currency areas have expanded by a total of about US$5½ trillion since 2007, and the ECB and Bank of Japan will add, between them, about another US$2½ trillion to that over the next couple of years. That central banks have had to take such extraordinary measures speaks both to the severity of the crisis that these countries faced and the limited capacity of other policies to support growth. History tells us that recovering from a financial crisis is an especially long and painful process, and more so if other countries are in the same boat. The direct effect of this unprecedented monetary easing has been to lower whole yield curves to extraordinarily low levels, and that process is continuing. The most pronounced effects can be seen in Europe. If one were to invest in German government debt for any duration short of nine years, one would be paying the German government to take one’s money. The same can be said for Swiss government debt. Even some corporate debt in Europe has traded at negative yields. It seems likely that these European developments are also affecting long-term interest rates in the United States. These ultra-easy monetary policies have helped along the process of balance sheet repair, bringing households and businesses closer to the point where they can start to spend and hire and invest again. And, it has to be observed, it has made fiscal constraints on governments much less binding than they would otherwise have been. Lower interest rates also increase the value of assets that can be used as collateral. Banks’ willingness to supply credit is affected by their balance sheet’s strength, of course, but it seems to be improving even in Europe at present. For larger businesses with access to capital markets, borrowing terms have probably never been more favourable. Such policies are, then, working through the channels available to them to support demand. But these channels are financial in nature. They don’t directly create demand in the way that, for example, government fiscal actions do. They work on the incentives for private savers, borrowers and investors to alter their financial behaviour and, it is hoped in time, their spending behaviour. A striking feature of the global economy, according to World Bank and OECD data, is the low rate of capital investment spending by businesses. In fact, the rate of investment to GDP seems to have had a downward trend for a long time. One potential explanation is that there is a dearth of profitable investment opportunities. But another feature that catches one’s eye is that, post-crisis, the earnings yield on listed companies seems to have remained where it has historically been for a long time, even as the return on safe assets has collapsed to be close to zero (Graph 2). This seems to imply that the equity risk premium observed ex post has risen even as the risk-free rate has fallen and by about an offsetting amount. Perhaps this is partly explained by more sense of risk attached to future earnings, and/or a lower expected growth rate of future earnings. BIS central bankers’ speeches Graph 2 Or it might be explained simply by stickiness in the sorts of “hurdle rates” that decision makers expect investments to clear. I cannot speak about US corporates, but this would seem to be consistent with the observation that we tend to hear from Australian liaison contacts that the hurdle rates of return that boards of directors apply to investment propositions have not shifted, despite the exceptionally low returns available on low-risk assets. The possibility that, de facto, the risk premium being required by those who make decisions about real capital investment has risen by the same amount that the riskless rates affected by central banks have fallen may help to explain why we observe a pick-up in financial risktaking, but considerably less effect, so far, on ‘real economy’ risk-taking. Potential vulnerabilities Whether this is best seen as a temporary increase in risk aversion, a genuine dearth of investment opportunities, evidence of monetary policy “pushing on a string”, a portent of secular stagnation, or just unusually long lags in the effects of policy, will probably be debated for some time yet. I don’t pretend to know what that debate may conclude. In the meantime, we have to think about some of the vulnerabilities that may be associated with the build-up of financial risk-taking. This is one of the responsibilities of the Financial Stability Board, particularly (though not only) through its Standing Committee on Assessment of Vulnerabilities. Two factors stand out at present as potentially combining to heighten fragility at some point. The first arises from the sheer extent and longevity of the search for yield. As I have noted, compensation in financial instruments for various risks is very skinny indeed. Investors in the long-term debt of most sovereigns in the major countries are receiving very little – if any – compensation for inflation and only minimal compensation for term. Some model-based decompositions of bond yields suggest that term premia on US long-term debt and some sovereign debt in the euro area are actually negative. Compensation for credit risk is also narrow in many debt markets. BIS central bankers’ speeches Moreover, because the search for yield is a global phenomenon, considerable amounts of capital have flowed across borders. There is some evidence to suggest that as emerging country bond markets have developed, particularly in Asia, more issuers have been able to raise funds in their local currencies. This leaves the foreign exchange risk associated with the capital flows more with the investor rather than a local bank or corporate, which is a good development. Nonetheless, we don’t have full visibility of those risks and there has been a notable build-up of debt overall in some emerging markets. The other factor of importance is a set of structural changes in capital markets, where there are two key features worth noting. One is the expanding role of asset managers. The search for yield, and the general tendency since the crisis for some intermediation activity to migrate to the non-bank sector, has resulted in large inflows to asset managers since the crisis. Yet liquidity – the ability to shift significant quantities of assets in a short period without large price movements – has probably declined, which is the second of the structural changes worth noting. Certainly the willingness of banks and others to act as market-makers in the way they did in the past will have diminished considerably. Now, of course, to some extent this is a result of the changes to financial regulation which have aimed to improve the robustness of the financial system. We should be clear that it was intended that the cost of liquidity provision in markets be more fully borne by investors. Liquidity was under-priced prior to the crisis. Nonetheless, the question is whether end-investors truly appreciate that the availability of liquidity in the system has declined. Good asset managers have sufficient liquidity holdings to meet redemptions that may occur over any short time period and will also offer appropriate redemption terms and so pose only limited risks to the broader financial system. But the cost of holding the most liquid assets in a world of very low returns overall may pressure some asset managers to hold less genuine liquidity than they might otherwise. Meanwhile, the amount of client funds being managed is much larger than it was and we don’t know how all those investors will behave in a more stressed environment, should one eventuate. A key concern the official sector has is that investors may be assuming a degree of liquidity that will not actually be available in a more stressed situation. Putting all that together, we find a world where the banking system is much safer, but in capital markets some valuations are stretched, credit spreads are compressed, there has been significant cross-border capital flow and liquidity may be less available than investors are assuming. That raises the risk that a sell-off, were it to occur, could be abrupt. What might trigger such an event? The usual trigger people have in mind is a rise in US interest rates. The US economy now looks strong enough for the Federal Reserve to consider increasing its policy rate later in the year. In itself, this should be welcomed. And it will have been very well telegraphed. Understandably, the Fed is proceeding with the utmost caution. But it will also have been over nine years since the Fed previously raised interest rates. Some market participants won’t have lived through a Fed tightening cycle before. Hence, it would not be surprising to see some bumps along this road. A second trigger could come from slower growth in emerging markets. Growth has already weakened in some economies, several of which have been bruised by falling commodity prices. Capital that flowed into emerging markets could flow out again, perhaps when interest rates begin to rise in the United States. That would probably occur alongside an appreciating US dollar. So the distribution of credit risk and foreign currency risk will be of considerable importance. One can easily see why investors could become less forgiving of borrowers on a shaky footing, be they corporates or sovereigns. A complicating factor here is that the rise in US interest rates looks set to occur while the central banks of Japan and Europe are continuing an aggressive easing of monetary policy via balance sheet measures. The combined Japanese and European “QE” will be very BIS central bankers’ speeches substantial. The extent to which such funds will flow across borders will depend on which sorts of investors are ‘displaced’ from their sovereign debt holdings and what their risk appetites are. To the extent that funds do flow across borders, the proportions in which they flow to emerging markets, as opposed to the United States, will also be important. So there is a fair bit that we don’t know, but need to learn, about this environment. It will be important for the officials thinking about these and other risks to continue an effective dialogue with private market participants over the period ahead. Australia These major global trends have certainly affected financial and economic conditions in Australia. We see the effects of the search for yield all around us. Short and long-term interest rates are at record lows, but are still attractive to some international investors. Foreign capital has been attracted not just to debt instruments but to physical assets. The demand for commercial property has been particularly strong and meant that prices have risen even as rental income has softened and the outlook for construction seems reasonably subdued. That raises some risks, which we discussed in our recent Financial Stability Review. 1 We also noted the attention being given by APRA (Australian Prudential Regulation Authority) and ASIC (Australian Securities and Investments Commission) to risks in the housing market. APRA has announced benchmarks for a few aspects of banks’ housing lending standards and both APRA and the Reserve Bank will be monitoring the effects of these measures carefully; at this stage, it is still too early to judge them. We can only say that over the past few months, the rate of growth of credit for housing has not picked up further. Overall, we think the Australian financial system is resilient to a range of potential shocks, be they from home or abroad. Banks’ capital positions are sound and are being strengthened over time. They have little exposure to those economies that are under acute stress at present. Measures of asset quality – admittedly backward-looking ones – have been improving. But it is developments in the ‘real’ sector of the economy that, right at the minute, seem more in focus. The economy is continuing to adjust to the largest terms of trade episode it has faced in 150 years. As part of that adjustment, there has been a major expansion in the capital stock employed in the resources and energy sector, accomplished by exceptionally high rates of investment. These are now falling back quickly, exerting a major dampening effect on demand. There has been a major cycle in the exchange rate, which is still under way. There has been considerable change to the structure of the economy. This all happened as the major economies encountered the biggest financial crisis in several generations, with its very long-lasting after effects, and which also had an impact on Australian attitudes to spending and leverage. To say there have been some pretty powerful, and disparate, forces at work is something of an understatement, even for a central banker. At present, while growth in Australia’s group of trading partners is about average, and is higher than the rate of growth for the world economy as a whole, the nature of that growth is shifting. The growth in Chinese demand for iron ore, for example, has weakened at the same time that supply has been greatly increased, much of it from Australia. Iron ore prices are therefore falling and contributing to a fall in Australia’s terms of trade. As the terms of trade fall, and national income grows more slowly than it would have otherwise, adjustment is occurring in several ways: See < http://www.rba.gov.au/publications/fsr/2015/mar/html/contents.html>. BIS central bankers’ speeches • Incomes of those directly exposed to the resources sector, be it as employees, owners or service providers, are reduced. • Nominal wages generally are lower than otherwise. • The Australian dollar has declined and will very likely fall further yet, over time. This is one of the main ways that the lower national income is ‘transmitted’ to the population: purchasing power over foreign goods and services is reduced. At the same time, Australians receive some price incentives to substitute towards domestically produced goods and services. And the purchasing power of foreigners over the value added by Australian labour and capital is higher than otherwise. • Saving by households, which rose when the terms of trade rose, is tending to decline as the terms of trade fall. This is a natural response to lower income growth and is being reinforced by easier monetary policy, which has reduced the return on safe financial assets. That said, the fact that many households already carry a considerable debt burden means that the extent to which they will be prepared to reduce saving to fund consumption may be less than it once was. More on this in a moment. • As part of the same adjustment, government saving is increasing more slowly (more accurately, government dis-saving is lessening more slowly) than otherwise. This is more or less automatic to the extent that lower commodity prices directly reduce state and federal government revenues. More generally, the more reluctant households are to lower their saving and increase their spending the harder the government may find it to increase its saving. Macroeconomic policy is supporting the adjustment. On the fiscal front, the government has little choice but to accept the slower path of deficit reduction over the near term. But over the longer term, hard thinking still needs to occur about the persistent gap we are likely to see (under current policy settings) between the government’s permanent income via taxes and its permanent spending on the provision of good and services. In the case of monetary policy, the Reserve Bank has been offering support to demand, consistent with its mandate as expressed by the medium-term inflation target. Relevant considerations of late include the fact that output is below conventional estimates of “potential”, aggregate demand still seems on the soft side as resources investment falls sharply, and unemployment is elevated and above most estimates of “natural rates” or “NAIRUs”. And inflation is forecast to be consistent with the 2–3 per cent target. So interest rates should be quite accommodative and the question of whether they should be reduced further has to be on the table. What complicates the situation is that these are not the only pertinent facts. A good deal of the effect of easier monetary policy comes via the housing sector – through higher prices, which increase perceived wealth and encourage higher construction, through higher spending on durables associated with new dwellings, and so on. These are not the only channels but, according to research, together they account for quite a bit of the direct effects of easier monetary policy. And they do appear to be working, thus far. Housing starts will reach high levels this year and wealth effects do appear to be helping consumption, which is rising faster than income. But household leverage starts from a high level, having risen a great deal in the 1990s and early 2000s. The extent to which further increases in leverage should be encouraged is not easily answered, but nor can it be conveniently side-stepped. Even if we chose to ignore it, monetary policy’s ability to support demand by inducing households to bring forward spending that would otherwise be done in future might well turn out to be weaker than it used to be. For a start, households already did a lot of that in the past and, in any event, future income growth itself looks lower than it did a few years ago. BIS central bankers’ speeches Then there are dwelling prices, which, at a national level, have already risen considerably from their previous lows, at a time when income growth has been slowing. Popular commentary is, in my opinion, too focused on Sydney prices and pays too little attention to the more disparate trends among the other 80 per cent of Australia. That said, it is hard to escape the conclusion that Sydney prices – up by a third since 2012 – look rather exuberant. Credit conditions are only one of several factors at work here. But credit conditions are very easy. So while the conduct of monetary policy can’t allow these financial considerations to dominate the “real economy” ones completely, nor can it simply ignore them. A balance has to be found. To this point, the balance that the Reserve Bank Board has struck has seen the policy rate held at what would once have been seen as extraordinarily low levels for quite a while now. The Board has, moreover, clearly signalled a willingness to lower it even further, should that be helpful in securing sustainable economic growth. The Board has been proceeding with a degree of caution that is appropriate in the circumstances. It also has, I would say, a realistic assessment of how much monetary policy can be expected to achieve in supporting the adjustment the economy needs to make. Any help in boosting sustainable growth from other policies would, of course, be welcome. In particular, things that could credibly be seen as lifting prospects for future income, and increasing confidence in those prospects, would give easy monetary policy a good deal more traction. In fact, that point generalises to the rest of the world. Across much of the world, too much weight is being put on monetary policy to try to achieve what it can’t: a durable and sustainable increase in growth, in an environment where private leverage is already rather high or even too high. Monetary policy alone won’t deliver that. This is probably a moment to recall the commitments we all made in the G20 meetings in Australia last year, as we agreed on the goal of an additional rise in global GDP of 2 per cent over five years. Those commitments were not actually about monetary policy; they were about other policies. It will be important this year, after one of the five years has passed, to see whether we are all making good on our various promises. More generally, actions which promote entrepreneurship, innovation, adaptation and skill-building, that reward “real” risk-taking, while providing a stable macroeconomic environment and a well-functioning financial system, will best support our future wellbeing. Thank you. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 4 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Financial Review Banking & Wealth Summit, Sydney, 28 April 2015. | Glenn Stevens: Observations on the financial system Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Financial Review Banking & Wealth Summit, Sydney, 28 April 2015. * * * I thank Elliott James for assistance in compiling these remarks. Good morning and thank you to the Australian Financial Review for inviting me to speak here today. Your conference comes at an opportune time, since there are plenty of things to talk about. Global financial markets are still in the grip of a pervasive search for yield. Major regulatory reform proposals are still being designed and implemented at the global level. Meanwhile, technological change is continuing to offer new opportunities for businesses to serve customers and disrupting established ways of doing things. And, not least, the Financial System Inquiry released its Final Report late last year. You have a very extensive list of speakers over the next two days who will no doubt cover all this territory and more. So my remarks will be fairly general only. Ahead of next week’s meeting of the Reserve Bank Board, I have no comments to offer today on monetary policy. Perhaps I might begin with a few remarks about the Financial System Inquiry. The Reserve Bank welcomes the Inquiry’s Report. The Inquiry had a distinguished committee, a capable secretariat, and an effective and robust process of discussion and engagement. The Bank found its own engagement with the Committee very constructive. The Report is comprehensive and shows the Inquiry grappling with the big issues of our time. I hope the Chairman will not mind me saying that all Inquiries are, inevitably, shaped to some extent by the circumstances they face. The Campbell Inquiry came at a time when the weight of informed opinion had already shifted quite a way towards favouring deregulation. After a long period of experience with a highly regulated system, the limitations were, by the mid 1970s, increasingly apparent. So the push was towards a financial system where market forces dictated more of the terms of engagement. That deregulatory mindset helped prepare the ground for two of the most significant – and beneficial – changes our financial system has seen in modern times. Floating the exchange rate was one of them. The other was removing constraints on competition in the banking system. By the time the Wallis Inquiry came around in the mid 1990s the financial system had undergone significant change. There had been an influx of new banks. There had been a sharp run-up in credit, a boom in asset prices, a bust and a painful recession in the early 1990s. The importance of capital and supervision had been reinforced. But by the mid 1990s, developments in technology and the anticipated growth of capital markets loomed large and shaped the environment for that Inquiry. The importance of payments systems was much more on the radar screen. As you know, the Wallis recommendations transformed the regulatory architecture. APRA (Australian Prudential Regulation Authority) was created and took charge of bank supervision, a function previously performed by the Reserve Bank, and a new Payments System Board was created in the Bank with a mandate for efficiency and competition in the payments system as well as controlling risk and contributing to financial stability. ASIC (Australian Securities and Investments Commission) was given a stronger consumer protection mandate. BIS central bankers’ speeches That regulatory architecture continues today. There is no serious discussion about major change to it. Indeed, as has been noted before, the regulatory set-up and the Australian financial system more generally came through the most severe international financial crisis since the Great Depression very well. Not unscathed, not without some missteps or liquidity pressures and not without some credit losses. And not without some important supportive policy actions. But overall, we can certainly hold our heads up when the crisis narrative is told. At the same time, there are critical learnings for Australia from the experiences of those who had a worse time of it than us through the past seven years. We survived the crisis pretty well, but how do we avoid that leading to complacency? What do we have to do to protect against a future crisis? How should we respond to the wave of changes to global regulatory standards? Meanwhile, the technological frontier continues to move ahead quickly, even if in ways that Wallis could not foresee. And Australia’s privately funded retirement income system – growing at the time of Wallis but by now amounting to about 100 per cent of GDP – could not be omitted from any comprehensive review of the system. This, then, was the backdrop when the Murray Committee set to work. The Inquiry has eschewed wholesale changes in favour of more incremental ones. I do not intend to offer a point by point response to all the recommendations. Let me touch on just a few themes. The first is enhancing the banking system’s resilience. There are a few issues here, the most contentious of which is whether banks’ capital ratios, which have already risen since the crisis, should be a little higher still. The Inquiry concluded that they should. There has been a lot of debate about just where current capital ratios for Australian banks stand in the international rankings. The reason there is so much debate is because such comparisons are difficult to make. There seems little doubt, though, that most supervisory authorities (and for that matter most banks) around the world have, since the crisis, revised their thinking on how much capital is needed and none of those revisions has been downward. So wherever we stood at a point in time, just to hold that place requires more capital. And it’s likely to be demanded by the market. There’s generally not much doubt about which way the world is moving. Of course, capital is not costless. If capital requirements become too onerous then the higher cost of borrowing could impinge on economic growth. But more capital brings the benefit of a more resilient system, one less prone to crisis and one more able to recover if a crisis does occur. Crises are infrequent, but very expensive. So there is a cost-benefit calculation to be done, or a trade-off to be struck – higher-cost intermediation, perhaps slightly reduced average economic growth in normal times, in return for the reduced probability, and impact, of deep downturns associated with financial crises. The Inquiry, weighing the costs and benefits, concluded that the benefits of moving further in the direction of resilience outweigh the rather small estimated costs. The second set of issues surround “too-big-to-fail” institutions and their resolution. The Inquiry is to be commended for grappling with this. These issues are complex and even after substantial regulatory reform at the global level, there is still key work in progress. The stated aim of all that work is to get to a situation where, with the right tools and preparation, it would be possible to resolve a failing bank (or non-bank) of systemic importance, without disrupting the provision of its critical functions and without balance sheet support from the public sector. This is explicitly for globally systemic entities, but the Inquiry has, sensibly enough, seen the parallel issue for domestically systemic ones as worthy of discussion. Ending ‘too-big-to-fail’ is an ambitious and demanding objective. To achieve it, not only must systemic institutions hold higher equity capital buffers, but more tools to absorb losses are needed in the event the equity is depleted. Typically envisaged is a “bail-in” of some kind, in BIS central bankers’ speeches which a wider group of creditors would effectively become equity holders, and who would share in the losses sustained by a failing entity. For this to work, there needs to be a market for the relevant securities that is genuinely independent of the deposit-taking sector – we can’t have banks hold one another’s bail-in debt. In a resolution, a host of operational complexities would also have to be sorted out. A resolution needs the support of foreign regulators if it is to be recognised across borders. It needs temporary stays on derivatives contracts so that counterparties don’t scramble for collateral at the onset of resolution. And it needs to be structured and governed well enough to withstand potential legal challenges and sustain market confidence. A proposal for “total loss-absorbing capacity”, or TLAC, was announced at the G20 Summit in Brisbane last year. Consultations and impact assessments are under way, and an international standard on loss-absorbing capacity will be agreed by the G20 Summit in Antalya later this year; guidance on core policies to support cross-border recognition of resolution actions should be finalised shortly after. It is fair to say that in its main submission to the Inquiry, the Reserve Bank counselled caution as far as “bail-in” and so on is concerned. We would still do so. The Inquiry also favours a cautious approach. Again, though, the world seems to be moving in this general direction. It isn’t really going to be credible or prudent for Australia, with some large institutions that everyone can see are locally systemic, not to keep working on improvements to resolution arrangements. The third set of recommendations from the Inquiry I want to touch on are those related to the payments system. The Inquiry generally supported the steps the Payments System Board (PSB) has taken since its creation after Wallis, but raised a few areas where the Board could consider consulting on possible further steps. As it happens, these dovetail well with issues that the PSB has been considering for some time. The Reserve Bank has since announced a review of card payments regulation and released an Issues Paper in early March. Among other things, it contemplates the potential for changes to the regulation of card surcharges and interchange fees. Surcharging tends to be a “hot button” issue with consumers and generated a large number of (largely identical) submissions to the Financial System Inquiry. But virtually all of the public’s concern is directed at a couple of industries where surcharges appear to be well in excess of acceptance costs, at least for some transactions. The Bank considers that its decision to allow surcharging of card payments in 2002 has been a valuable reform. It allows merchants to signal to consumers that there are differences in the cost of payment methods used at the checkout. By helping to hold down the cost of payments to merchants, the right to surcharge can help to hold down the prices of goods and services more generally. The Bank made some incremental changes to the regulation of surcharging in 2013, but to date these have had a relatively limited effect on the cases of surcharging that most concern consumers. Our current review will consider ways we can retain the considerable benefits of allowing merchants to surcharge, while addressing concerns about excessive surcharges. One element of this might be, as the Financial System Inquiry suggests, to prevent surcharges for some payment methods, such as debit cards, if they were sufficiently low cost. This would mean that in most cases consumers would have better access to a payment method that is not surcharged, even when transacting online. Other options being considered are ways to make the permissible surcharge clearer, whether through establishing a fixed maximum or by establishing a more readily observable measure of acceptance costs. The capping of card interchange fees is also now a longstanding policy and, we think, a beneficial one. Nonetheless, it is important to ensure that it continues to meet its objectives. Caps were put in place in 2003 based on concerns that interchange fees in mature payment systems can distort payment choices and, perversely, be driven higher by competition between payment schemes. As suggested by the Inquiry, the Bank’s review will consider BIS central bankers’ speeches whether the levels of the current caps remain appropriate. We know, for example, that lower caps have now been set in some other jurisdictions. But there are other elements of the current regime that also warrant consideration. For instance, while average interchange fees meet the regulated caps, the dispersion of interchange rates around the average has increased significantly over time. The practical effect of this is that there can be a difference of up to 180 basis points in the cost of the same card presented at different merchants. This problem is aggravated by the fact that merchants often have no way of determining which are the high-cost cards. Although the wide range of interchange fees is not unique to Australia, we would want to ensure so far as possible that the regulatory framework does not contribute to this trend or to declining transparency of individual card costs to merchants. The Bank’s review will consider a range of options, including “hard” caps on interchange fees and hybrid solutions, along with setting more frequent compliance points for caps. Options for improving the ability of merchants to respond to differing card costs will also be considered. While considering interchange fees, it is also appropriate to consider the circumstances of card systems that directly compete with the interchange-regulated schemes. This means, in particular, bank-issued cards that do not technically carry an interchange fee, but nonetheless are supported by payments to the issuer funded by merchant fees. More broadly, all the elements I have mentioned – interchange fees, transparency and surcharging – are interrelated, which means that there are potentially multiple paths to achieving similar outcomes. I encourage those with an interest to engage with the Bank in the review process in the period ahead. Turning away from the Financial System Inquiry to other matters, let me mention two. I said at the beginning that the “search for yield” continues. There is a line of discussion that tackles this issue from a cyclical point of view, thinking about how the balance sheet measures taken by the major central banks are affecting markets, the extent and nature of cross-border spillovers, what happens when the US Federal Reserve starts to tighten policy at some point and so on. I’ve spoken about such things elsewhere and have nothing to add today. There is another conversation, however, that tends to take place at a lower volume, but which definitely needs to be had. That conversation is about what all this means for the retirement income system over the longer run. The key question is: how will an adequate flow of income be generated for the retired community in the future, in a world in which longterm nominal returns on low-risk assets are so low? This is a global question. Just about everywhere in the world the price of buying a given annual flow of future income has gone up a lot. Those seeking to make that purchase now – that is, those on the brink of leaving the workforce – are in a much worse position than those who made it a decade ago. They have to accept a lot more risk to generate the expected flow of future income they want. The problem must be acute in Europe, where sovereign yields in some countries are negative for significant durations. But it is also potentially a non-trivial issue in our own country. In a conference about wealth, this might be a worthy topic of discussion. And the final issue is misconduct. This has loomed larger for longer in many jurisdictions than we would have thought likely a few years ago. Investigations and prosecutions for alleged past misconduct are ongoing. It seems our own country has not been entirely immune from some of this. Without in any way wanting to pass judgement on any particular case, root causes seem to include distorted incentives coupled with an erosion of a culture that placed great store on acting in a trustworthy way. Finance depends on trust. In fact, in the end, it can depend on little else. Where trust has been damaged, repair has to be made. Both industry and the official community are working hard to try to clarify expected standards of behaviour. Various codes of practice are being BIS central bankers’ speeches developed, calculation methodologies are being refined, and so on. 1 In some cases regulation is being contemplated. Initiatives like the Banking and Finance Oath also can make a very worthwhile contribution, if enough people are prepared to sign up and exhibit the promised behaviour. 2 In the end, though, you can’t legislate for culture or character. Culture has to be nurtured, which is not a costless exercise. Character has to be developed and exemplified in behaviour. For all of us in the financial services and official sectors, this is a never-ending task. With those few remarks, I wish you a successful conference. Thank you. See, for example, http://www.financialstabilityboard.org/2014/09/r_140930/ and Codes of Best Market Practice and Shared Global Principles. See http://www.thebfo.org/home. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 4 |
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at the Corporate Finance Forum, Sydney, 18 May 2015. | Philip Lowe: Managing two transitions Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at the Corporate Finance Forum, Sydney, 18 May 2015. * * * Accompanying graphs can be found at the end of the speech. I would like to thank Kevin Lane for assistance in the preparation of these remarks. Thank you very much for the invitation to be part of this year’s Corporate Finance Forum. It is a pleasure to be here and to be able to address so many of Australia’s leading CFOs. This morning, I would like to talk about two transitions. The first is a domestic one – that is, the transition in the Australian economy following a period of extraordinarily strong growth in investment in the resources sector combined with record high commodity prices. The second is a much more international one – and that is what seems to be a transition to a world in which global interest rates are lower, at least for an extended period, than we had previously become used to. As CFOs, I suspect that you have a keen interest in both of these. The transition in the Australian economy So, first, the transition in the Australian economy. I am sure you are all familiar with the basic story here. In the middle of the previous decade, global commodity prices rose sharply, largely on the back of strong growth in China. In response, investment in the resources sector in Australia picked up considerably to take advantage of these high prices and Australia’s endowment of natural resources, especially iron ore, coal and natural gas. These developments, which were interrupted briefly by the financial crisis of 2008 and 2009, can be seen clearly in this first graph (Graph 1). By 2012, mining investment, as a share of GDP, peaked at its highest level in at least a century. The good news is that all this investment has considerably expanded Australia’s capital stock, and thus our productive capacity. This is now flowing through into higher resource production and exports, and it will continue to do so for many years to come (Graph 2). In 2014, the tonnage of iron ore exported was double that of five years earlier, while the tonnage of coal exported was up 40 per cent over this same period. There has also been growth in LNG exports, although the really big increases still lie ahead of us. All up, growth in resource exports has contributed around 1 percentage point to annual GDP growth over recent years, and this is expected to continue into the foreseeable future, particularly as more LNG projects come on line. However, the big lift in our capital stock is now drawing to a close and investment in the resources sector is declining towards more normal levels. Last year, it fell by 12 per cent and similar, or larger, falls are expected in both 2015 and 2016. At the same time, the increase in supply made possible by all this investment, both in Australia and elsewhere, has seen the prices of a number of our key exports decline significantly. Importantly, when investment in the resources sector was at its peak, we avoided the economy overheating as it had in the past when we had much smaller resources booms. This was a significant achievement. In effect, other parts of the economy made way so that we could accommodate the large addition to the capital stock in the resources sector without the overall economy overheating. But now we are in a period of transition to the next phase. BIS central bankers’ speeches In this new phase, these other parts of the economy could be expected to grow more strongly than they had during the investment boom. In a perfect world, we might expect that this transition would be a perfectly seamless one – for non-mining activity to pick up at exactly the right time, and by exactly the right magnitude, to perfectly offset the decline in mining investment. In the real world though, things are not so simple, and it is perhaps unrealistic to expect that a transition of this magnitude could be finetuned so well as to keep the economy in perfect equilibrium. Over the past three years, GDP growth has averaged around 2½ per cent, and the RBA’s latest forecasts, which were released around 10 days ago, have this type of growth continuing for a while yet (Graph 3). While in many other developed economies, growth of 2½ per cent would be viewed fairly favourably, it is below what we have become used to in Australia and it is below what we are capable of. As a result, there has been a build-up of spare capacity in the overall economy. So, the transition that is taking place is not exactly seamless. However, we should have some confidence that a successful transition can be made, particularly given our flexible market-based economy. Among other things, this transition is being assisted by three developments: the lower exchange rate; restraint in aggregate wage growth; and the stimulatory setting of monetary policy. In terms of the exchange rate, over the past two years the Australian dollar has depreciated by around 20 per cent on a trade-weighted basis and by around 25 per cent against the US dollar. We are now starting to see signs that this depreciation is boosting activity in various parts of the economy. One of these is tourism, with exports of travel services rising again, as more people visit Australia and spend more money here (Graph 4). 1 Conversely, imports of travel services have declined as more Australians holiday domestically. The lower exchange rate has also improved prospects in a number of other export-oriented industries, including some parts of manufacturing, agriculture and even mining. The second factor helping with the transition is modest wage growth. Over the past couple of years, aggregate wage growth has slowed noticeably and it is now running at the slowest pace in many years (Graph 5). While this means that average living standards are not increasing at the rate they were during the investment boom, the slower growth in wages is helping to improve the competitiveness of the Australian economy. Lower wage growth, by supporting employment growth, is also helping to share the burden of adjustment across the broader community. In this context, it is notable that for the past nine months, employment growth has been strong enough to keep the unemployment rate broadly steady, even though GDP growth has been below average. The third factor assisting with the transition is the low level of interest rates. The effects are perhaps clearest in residential construction which increased by 8 per cent in 2014. And with building approvals continuing at very high levels over recent months, particularly for apartments, we can look forward to further increases in construction activity over the months ahead (Graph 6). Low interest rates are also helping to boost household consumption. They are doing this by improving the aggregate cash flow of the household sector and boosting household wealth. However, as I have spoken about previously, the overall effect on consumption is probably smaller, or at least slower, than it was in the past. 2 This is because high debt levels mean that households are less inclined than they once were to respond to low interest rates by borrowing to increase their spending. Notwithstanding this, there is still a spending response Some of this rise is also related to a pick-up in education-related travel following changes to arrangements for student visas since 2012. See Lowe P (2015), “Low Inflation in a World of Monetary Stimulus”, Speech to the Goldman Sachs Annual Global Macro Economic Conference, Sydney, 5 March. BIS central bankers’ speeches to low interest rates and household consumption rose by nearly 3 per cent in 2014. This is slower growth than in the period from the mid-1990s to the mid 2000s, but it is faster than current growth in real household income. The part of the transition that is taking place more slowly than we had earlier expected is the lift in business investment outside the resources sector. As a share of GDP, non-mining business investment remains just above the levels reached in the recession of the early 1990s (Graph 7). For a few years now, each time we have updated our forecasts, we have pushed out the timing of the recovery in this part of the economy. The latest update was no different. Many businesses tell us that while conditions are okay at the moment, they are not sufficiently strong for them to lift their investment plans. Many feel uncertain about the future and so are waiting until there is a sustained pick-up in demand before committing to new capital expenditure. There is no single factor driving this tendency to wait and a similar story seems to be playing out in many other advanced economies. Around the world, many businesses seem concerned about the prospects for consumer demand given high levels of debt and the ageing of the population. There is also uncertainty about what type of capital investment is appropriate in a world where new information technologies are reshaping business models. Many firms also see globalisation of markets as a challenge, especially where increased competition has reduced market power. Overall then, a lift in non-mining investment remains the critical ingredient to stronger growth in the overall economy and to a successful transition. Many of the preconditions for this to occur are in place, although a sustained lift still seems some way off. I will return to this issue in a few moments. The transition in global interest rates But I would now like to turn to the second transition that I mentioned at the outset – that is, to a world in which global interest rates are lower than we had previously become used to. Perhaps the best way to see this is with a couple of graphs. The first shows the average policy rate set by the US Federal Reserve, the European Central Bank and the Bank of Japan (Graph 8). With all three central banks setting their policy rate at, or very close to, zero, the average global policy rate is the lowest on record. The next graph shows the yields on 10-year government bonds in the United States, Germany and Japan (Graph 9). Again, in all three cases these rates are at extraordinarily low levels, even after the increases over recent weeks. These very low rates mean that savers investing in risk-free assets earn negative real rates of return. They also mean that the time value of money is negative. And they mean that there is no compensation for postponing consumption to tomorrow. So, how do we find ourselves in this remarkable situation? The proximate cause is the decisions taken by world’s major central banks to set their policy rates at these historically low levels and to buy unprecedented amounts of assets from the private sector. But central banks do not act in a vacuum. They respond to the world in which they find themselves. And, that world is one in which there is an elevated desire to save relative to the desire to invest. And when the appetite for saving is high and few people want to use those savings to invest in new assets, the return to saving is, unfortunately, inevitably low. We should all hope that this period of extraordinarily low interest rates does not persist for too much longer: that, over time, confidence lifts and once again businesses compete strongly for the world’s available pool of savings to fund investment in productive assets. Once this happens, higher returns will again be offered to savers. My own view is that there BIS central bankers’ speeches is a reasonable prospect that, in time, this will indeed take place and that some normalisation of interest rates will occur. But it also seems plausible that the average return on savings, at least for a protracted period, will be lower than it had been previously. The population in many countries is ageing, aggregate household indebtedness is high and many of the service industries that are growing relatively quickly are not particularly intensive in physical capital. Taken together, these trends might be expected to boost the desire to save relative to invest and thus lead to a structurally lower level of global interest rates than otherwise. Of course, we can’t be sure that things will play out like this. Many other factors influence global saving and investment decisions, including what happens in the populous developing countries in Asia. But what we do know is that even if the current low level of interest rates is entirely cyclical – and has no structural element at all – it is proving to be highly persistent indeed. As CFOs, I suspect that for many of you this is complicating your job and posing new questions and challenges. In this context, I would like to touch briefly on three issues. The first is the challenge that low interest rates pose to anyone who is seeking to fund future liabilities. Low interest rates mean that the present discounted value of these liabilities is higher than it once was. In turn, this means that more assets are needed to cover these liabilities. For anyone managing a long-tail insurance business or a defined benefit pension scheme, this is a major challenge. It is also a challenge for retirees and those planning for retirement. The second issue is the effect of low interest rates on asset prices. Just as low interest rates increase the value of future liabilities, they increase the value of a given stream of future revenue from any asset. The result is higher asset prices. Another way of looking at this is that faced with low returns on risk-free assets, investors have sought other assets, and in so doing they have pushed up the prices of these assets. A good example of this is commercial property, where investors have been attracted by the relatively high yields, pushing prices up even though rents are declining (Graph 10). A rise in asset prices is, of course, part of the monetary transmission mechanism. But developments here need to be watched very carefully. History is littered with examples of unsustainable asset price rises emerging on the back of perfectly justifiable increases in prices. In a number of cases, this has ended badly, especially if there is leverage involved. Also, we should not lose sight of the fact that interest rates and the returns generated from assets are ultimately linked to one another. So, interest rates may be structurally lower in part because the stream of future income generated from assets is also lower than in the past. This would have obvious implications for the sustainable level of many asset prices. The third issue is the effect of low interest rates on firms’ investment decisions and hurdle rates of return. In today’s environment, it seems that many investors have, reluctantly, come to accept that they will earn lower yields on their existing assets. An open question though is whether the same acceptance of lower returns is flowing through to firms’ decisions about the creation of new assets – that is, their own investment plans. The international evidence is that the hurdle rates of return that firms use for new investment are quite sticky and that they are not very responsive to movements in interest rates. 3 There is less evidence of this issue in Australia, but a recent survey of CFOs by Deloitte hints at the For example, see Sharpe S and Gustavo Suarez (2013), “Do CFOs Think Investment is Sensitive to Interest Rates?”, FEDS Notes, 26 September. Available at <http://www.federalreserve.gov/econresdata/notes/fedsnotes/2013/do-cfos-think-investment-is-sensitive-to-interest-rates-20130926.html>. BIS central bankers’ speeches same conclusion. The survey results suggest that hurdle rates of return on new investment are typically above 10 per cent and sometimes considerably so (Graph 11). The results also suggest that the average margin between the hurdle rate of return and the weighted-average cost of capital is about 3 percentage points. As part of the survey, firms were also asked how often they changed the hurdle rate, with the most frequent answer being “very rarely”. These findings are very similar to those reached through the Bank’s own extensive business liaison program. One issue that this raises is what is the appropriate hurdle rate of return in a world of persistently low interest rates? Each CFO will no doubt have a different answer to this, but in a world of persistently low interest rates, it may well turn out that the average answer is – or should be – lower than it used to be. Recently, in a number of countries there has been a tendency for firms to return funds to shareholders. These firms are effectively saying to their shareholders, “here, you manage the money, as we do not have investment opportunities that satisfy our internal rate of return.” In many cases, shareholders have welcomed this, seeing it as a disciplined approach to capital management. The difficulty is that if the majority of firms act in this way, shareholders in aggregate get left holding the cash. And, on that cash, they earn very low rates of return – almost certainly lower than the rate of return that would, on average, be earned if that cash were invested by businesses in real assets. This is really just another way of saying that if the appetite for investment is low, savers, in the end, will get low returns on their savings. So, as I said, this world of low interest rates is creating many challenges for you as CFOs – whether you are a CFO needing to fund future liabilities, a CFO valuing and managing assets or a CFO determining the appropriate hurdle rate of return for your firm’s investment decisions. This world is also creating challenges for managing the first transition that I spoke about – that in the Australian economy. The large monetary expansion abroad and low interest rates of the major central banks have meant that the value of the Australian dollar has been higher than would otherwise have been the case. In this context, it is difficult to escape the conclusion that a further depreciation of the Australian dollar would be helpful in the transition of the Australian economy. In this challenging global environment, the RBA is seeking to play a constructive role. As I said earlier, low interest rates are supporting spending in the economy. The further reduction in the cash rate earlier this month will provide a bit more support and it will help reinforce some of the recent encouraging signs, particularly in household spending. In time, stronger consumption growth and a continuation of the pick-up in residential construction should lead to a lift in business investment. It is, however, unlikely to be in Australia’s long-term interests to engineer a consumption boom by encouraging people to borrow large amounts against future income. This is especially so when debt levels are already high and prospects for future income growth are not as positive as they once were. So, there is a fairly fine line to tread here. The RBA’s recent decisions have sought to strike a prudent balance – to help encourage consumption growth and thus business investment, but avoid the type of imbalances that could cause problems later on. We will continue to assess that balance carefully. Of course, the more enduring solution to the two issues I have talked about – the transition in the Australian economy and low returns to savers – is an improvement in the underlying investment environment. This is a challenge not just in Australia, but in almost all advanced economies. Unfortunately, there is no magic lever here, but the good news is that the task is not an impossible one! Thank you for listening and I would be happy to answer your questions. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches | reserve bank of australia | 2,015 | 5 |
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Cards & Payments Conference, Melbourne, 21 May 2015. | Malcolm Edey: Card payments regulation – from Wallis to Murray Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Cards & Payments Conference, Melbourne, 21 May 2015. * * * Thank you for the invitation to speak here today. I have been asked to talk about the outlook for payments regulation. This is a subject that is very much front of mind at present, given that the Murray Inquiry only recently presented its findings in that area and the Reserve Bank Payments System Board (the PSB) is conducting its own review following on from the Murray recommendations. I’ll say a bit more about that later, but I have to begin by saying that the PSB’s review process is still underway, and I am not going to pre-empt any conclusions that might come from that. Instead, I want to address the topic in a more indirect way, by giving an overview of the PSB’s general approach to retail payments since it first entered the field. In doing so, I hope to bring out some key principles that have been consistently applied and which remain part of the ongoing policy framework. The Reserve Bank’s role as a regulator of retail payments systems was established following the report of the Wallis Inquiry in 1997. Like Murray, the Wallis Inquiry was about more than just payments. It was about the financial system as a whole, and Wallis took a holistic approach to understanding the role of payments within the wider system. I suggest there were four key observations that determined the overall shape of the Wallis recommendations. First, Wallis observed that the business model of traditional banking was fundamentally changing. In simplified terms, banks could be thought of as suppliers of a portfolio of products, the three main ones being deposits, loans and transaction services. In the earlier highly regulated world, these were bound together in full-service banking institutions. Credit was heavily rationed and potential borrowers needed to demonstrate loyalty to a bank in order to qualify for loans. This environment tended to produce outcomes where net interest margins were high, customers were immobile and banks cross-subsidised payment services effectively as a utility. This model broke down over time because of the combined effects of deregulation and financial innovation. These forces enabled new players to compete separately for the most profitable business lines. Examples were cash management trusts on the deposit side, which enabled depositors to gain access to wholesale interest rates, and mortgage securitisers on the lending side, which competed separately for lending business at lower margins. This was the phenomenon of “unbundling”. It meant that cross subsidies were competed away and the different components of banking services had to be separately priced, including payments. One of the manifestations of this, noted by Wallis, was the increased incidence of highly unpopular transaction fees for bank accounts. But of course the implications were much broader than that and are still being seen across the financial system today. Second, Wallis noted the importance of technology and innovation. Today, at a conference like this, it is impossible not to be struck by the pace of change in payments technology. Of course, the specifics of that couldn’t have been foreseen 18 years ago when Wallis presented his report. What the report did foresee was the general tendency for the system to innovate and the associated trends towards electronic and card-based payments, away from traditional instruments like cash and cheques. Again, this is a process that is continuing today. Third, and related to the first two points, Wallis foresaw the growth of payment systems as a business, in contrast to the utility-based model that I described earlier. If commercial realities BIS central bankers’ speeches were leading to the unbundling of payments from other financial services, then it was to be expected that this business would open up to innovative and specialist providers. It also meant that existing players would need to put their own payments services on a more commercial footing. And lastly, Wallis looked at the regulatory implications of these developments. Payments systems are networks which link service providers and their customers. That means that they need to have ways of ensuring adequate coordination among network members who would normally be competitors. This in turn raises a whole suite of questions as to whether particular network arrangements are generating efficient outcomes: for example, is there appropriate access to networks for new players, are network pricing arrangements efficient and are there effective coordination mechanisms to promote network innovation? Wallis concluded that there was a need for regulatory oversight of payment systems, and the recommendations that flowed from that formed the basis for the arrangements we have today. To summarise the main elements, Wallis recommended that: • the Reserve Bank be given powers as payments regulator; • those powers should be vested in a separate board with a majority of independent directors (the Payments System Board); • the mandate of that board should be to promote efficiency, stability and competition in payments systems; and • as a starting point, the PSB should look at credit card schemes, with particular focus on access arrangements, pricing and scheme rules. Wallis also recommended that the PSB maintain a more general watching brief on the efficiency of the system as a whole. Looking back on the work of the PSB since that time, it has very much followed the original Wallis outline and philosophy. Early work of the PSB focused on credit card systems, leading to a package of reforms in 2003. This was followed by reforms to debit card systems in 2006 and to the ATM network in 2009. In implementing the Wallis recommendations, the government’s intention was that the policy approach should be co-regulatory. The explanatory memorandum to the law which set up the PSB’s powers in 1998 stated that: The philosophy of the Bill … is co-regulatory. Industry will continue to operate by self-regulation in so far as such regulation promotes an efficient, competitive and stable payments system. Where the RBA considers it in the public interest to intervene, the Bill empowers it to designate a payment system and develop access regimes and standards in close consultation with industry and other interested parties. 1 The approach taken by the PSB since its inception has been consistent with that intent. The PSB directly regulates only five payment systems (namely ATMs, eftpos, MasterCard and Visa credit, and Visa Debit) and only in limited areas – that is, the level of interchange fees, restrictions on merchants, transparency and access. In contrast to the more interventionist approach of some other jurisdictions, the Australian framework leaves many aspects of the payments system unregulated. This philosophical approach has also very much guided the PSB’s work on payments innovation. Payments Systems (Regulation) Bill 1998, Explanatory Memorandum, p 12. BIS central bankers’ speeches I have already mentioned the industry’s enormous capacity to innovate. In talking about this subject, however, it is important to distinguish between proprietary innovations, which are carried out at the level of particular payment businesses, and network innovation, which occurs at the level of the system as a whole. As you would expect, the industry is very good at innovation in the proprietary space. Among the many examples of this are cardless ATM withdrawals, new authentication techniques such as fingerprint, mobile banking and payment apps and now digital wallets. These are areas where the incentives to innovate are clearly effective. But it is well recognised that efficient innovations can be more difficult to achieve at the level of the system as a whole, because the available incentives do not necessarily support coordinated action. Consistent with the Wallis vision, the PSB has been active in promoting coordinated industry solutions where that was in the public interest. An early example was in encouraging faster cheque clearing – an obvious improvement in system efficiency but one that couldn’t have been achieved without effective coordination. On a larger scale, the PSB more recently undertook its Strategic Review of Innovation in the Payments System, the results of which were published in 2012. 2 That review was conducted over a two year period and involved extensive consultations with both the payments industry and with users of payments services. It found a number of areas where there was scope for system improvements that could be achieved through coordinated action. The key areas were: • same-day settlement of direct entry transactions; • faster payments and out-of-hours payments to be made generally available; • capacity for richer information with payments; and • an easy addressing solution for electronic payments. The first one of these was delivered at the end of 2013 and essentially involved an acceleration of existing direct entry processes. The remaining three form a more ambitious agenda and are together being taken up as part of the industry’s New Payments Platform (the NPP project). The NPP is a successful example of what can be done through collaboration between the industry and its regulator. It is also a good example of the catalyst role for the PSB in promoting system innovation that was envisaged by Wallis. While it is an industry-led project, it is strongly supported by the PSB, and the Board continues to encourage commitment to the project and to its timely completion. The project was launched in early 2013 and is now well advanced. On current scheduling the NPP will deliver a fast payments service with rich information and addressing capabilities in the second half of 2017. It will be linked to a fast settlement service provided by the Reserve Bank, which will allow transactions to be cleared and settled 24/7 in close to real time. All of this will amount to a world-class payments infrastructure. It will also be a platform for further innovation. One of the key decisions made at an early stage of the project was to separate the basic clearing and settlement infrastructure from the commercially based overlay services that would use it. The industry is committed to an initial overlay that is intended to provide an attractive service and drive early volume growth. But it is important to note that access to the overlay space has always been intended to be open and competitive. Over time, this structure will allow new and specialist providers to make use of the rich capabilities provided by the core infrastructure. RBA (2012), Strategic Review of Innovation in the Payments System: Conclusions, June. BIS central bankers’ speeches Before moving on to some more detailed regulatory matters, I will mention one more initiative to have come out the 2012 Strategic Review, and that is the establishment of new industry coordination and consultation arrangements. In line with a recommendation from the 2012 Review, a new industry coordination body, the Australian Payments Council, was launched last year. The Council is a high-level body representing a diverse range of industry participants including banks, payment schemes and other service providers. It will have the capacity to give strategic direction to the industry as well as engaging in dialogue with the PSB. At the same time, it is important that the policy process engages with users and not just suppliers of payment services. To facilitate that, the Reserve Bank has also set up a Payments User Consultation Group which began meeting late last year. In summary then, the policy work of the PSB has been very much consistent with the philosophy and objectives of the original Wallis reforms. A good deal of that work has been what might be termed “co-regulatory” in nature, in the sense that it involved promoting industry-led solutions rather than using formal regulatory powers. But of course the PSB does have a regulatory mandate, and it has used its powers to regulate a number of aspects of card payments where it judged that there was a public interest case to do so. Probably the aspects of this regulation that have attracted the most attention have been those related to interchange and surcharging, and I would like to make some general comments about each of these. First, interchange. The commercial function of interchange fees is a very interesting one. They serve as a device for shifting the benefit-cost balance between issuers and acquirers in a four-party scheme and therefore, indirectly, between cardholders and merchants. Payment schemes argue that this can be an important competitive device that can promote innovation, for example by being structured to encourage network growth or the take-up of new products. Typically, interchange flows from the acquirer to the issuer, and hence the fee structure tends to encourage issuance and use of a card, but may discourage acceptance by merchants if the fee is too high. For mature schemes, however, the capacity of merchants to refuse acceptance may be quite limited. As a result, it has been frequently observed that competition between schemes can have the effect of pushing fees up rather than down, in order to maximise incentives to issuers and cardholders. The reason that this kind of outcome is possible is that there is a misalignment between the incidence of these fees and the structure of decision-making power in a typical transaction. In a nutshell, the cardholder chooses the payment instrument but the merchant pays the fee. In designing its card payment reforms, both for credit and debit, the PSB concluded that competition of this nature was distorting price signals in a way that inefficiently encouraged the use of high cost cards and added to merchant costs. Hence, it judged that there was a case for interchange fees to be capped by regulation. A number of other jurisdictions have since taken a similar view. The second aspect that I want to talk about is surcharging. The PSB has consistently taken the view that merchants should not be prevented from surcharging for higher-cost payment methods. Scheme rules that prohibited surcharging had the effect of reinforcing the distortive effects of interchange fees by preventing costs from being passed on to cardholders. They also reduced the flexibility of merchants in deciding how to respond to high-cost payment instruments. The ability to surcharge improves merchants’ bargaining position by allowing them a greater range of responses, rather than just being faced with a binary decision to accept or reject a particular card. Efficient surcharging should of course reflect the underlying payment cost. The PSB’s initial reforms to credit and debit gave merchants the right to surcharge, while effectively relying on competition to ensure that surcharging would not be excessive. This regulation was revised in 2013 in response to concerns about practices that had developed since the initial reforms, particularly about surcharging that appeared excessive or unrelated to costs. The amended regulation still prevents schemes from imposing no-surcharge rules, but it allows them to limit BIS central bankers’ speeches surcharging to the reasonable cost of acceptance. In doing so it strikes a balance, at least in principle, between the rights of merchants and schemes. Merchants cannot be prevented from recovering reasonable acceptance costs, but they can be prevented by scheme rules from going beyond that. More on that in a moment. The PSB’s reforms to surcharging and interchange have formed part of a broader package that also included rules relating to access and transparency. I don’t have time to cover all of that today. But taken together, the effects have been beneficial. The system has continued to innovate, and merchants’ card payment costs have fallen. 3 It is also notable that these costs are significantly lower in Australia than in a jurisdiction like the United States, where reforms to card systems have been much more limited. 4 The Murray Report last year broadly endorsed the PSB’s reform approach while flagging a number of areas for further consideration, particularly in relation to surcharging and interchange. These have now been taken up as part of the PSB’s card payments review. The issue of surcharging remains contentious. Instances of apparently excessive surcharging have persisted. While they acknowledge arguments for what might be called a “no excessive surcharge” regime, the schemes have argued that the current formulation is too complicated and difficult for them to enforce. The card payments review is looking at several possible mechanisms for addressing this. One option proposed by Murray is a tiered approach that would allow tougher surcharging constraints to be placed on low-cost cards. A number of other options are available to strengthen enforcement and disclosure practices, for example allowing schemes to cap surcharges that are not percentage based at some low fixed amount. On interchange fee regulation there are a number of issues to consider. These include the overall level of the interchange cap, the complexity and proliferation of interchange categories, the phenomenon of interchange “drift” with the three-year compliance cycle, and the wide disparity between interchange rates for preferred merchants and those applying to others. While it broadly endorsed the PSB’s regulatory approach to date, the Murray Report recommended that consideration be given to tightening existing interchange regulations in some significant respects. These included lowering the overall interchange cap, and broadening its coverage to include other incentive payments that serve a similar function. It argued that this would help to prevent circumvention and, in the case of companion card arrangements, would improve competitive neutrality. All of these things are now being carefully considered. As I said at the outset, the review process is still underway and I won’t pre-empt any possible conclusions. Reserve Bank staff have already consulted extensively with interested parties, and I expect there will be more of that to come in response to the submissions received. I take the opportunity to thank industry participants for your constructive engagement, not just in this review but in the wider agenda of promoting a more efficient and innovative payments industry. Combining transactions across all card systems, average merchant service fees in Australia have fallen by 37 basis points from their level prior to the Bank’s reforms. See RBA (2014), Submission to the Financial System Inquiry, Sydney, p 213. Merchant service fees are around 75 basis points lower than in the United States. See RBA (2014), Submission to the Financial System Inquiry, March, p 213. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 5 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to Thomson Reuters' 3rd Australian Regulatory Summit, Sydney, 27 May 2015. | Philip Lowe: The transformation in maturity transformation Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to Thomson Reuters’ 3rd Australian Regulatory Summit, Sydney, 27 May 2015. * * * I would like to thank Fiona Price and Carl Schwartz for assistance in the preparation of these remarks. Accompanying graphs can be found at the end of the speech. Thank you very much for the invitation to be part of Thomson Reuters’ Third Australian Regulatory Summit. There is no shortage of things to talk about at such a summit. As you are all too aware, there has been a large wave of new regulatory requirements over recent years. The task of adjusting to these new requirements has been a time-consuming one for many of you and that task is not yet over. This wave of regulation, of course, has not just materialised out of thin air. Rather, it has been in response to the lessons learnt from the financial crisis. That crisis was extremely damaging for the citizens of many countries and the subsequent spotlight on financial institutions has highlighted not just poor risk-management practices but also some serious lapses in governance and ethics. As the various problems have emerged, they have strained the bonds of trust that are so important in finance. In response, regulators, and financial institutions themselves, have sought to reduce the probability of a repeat of the crisis and to rebuild trust in finance. On both accounts, there is still some way to go. If we look through all the detail of the various regulatory initiatives – and there is certainly a tremendous amount of detail – many of the specific measures stem from the desire to address risks that arise when the financial system undertakes maturity transformation – that is, when it transforms illiquid longer-term assets into liquid assets. So today, rather than go through the long list of regulatory reforms, I would like to focus my remarks around the way in which the financial system undertakes maturity transformation. Maturity transformation and the banking system The transformation of claims over fundamentally illiquid assets into claims that are highly liquid is one of the critical functions that the financial sector provides for the community. Without such transformation, it is difficult to see how modern economies would work. This transformation has been critical to the accumulation of physical capital in our societies as well as the operation of our modern payment systems. The best, and most obvious, example, of this type of transformation is an at-call bank deposit. 1 The holder of a deposit has a completely liquid claim on the bank – the full face value of the deposit can be drawn on at any time, for any purpose. Yet deposits are primarily invested in assets, namely bank loans, which, typically, are not particularly liquid and have long maturities. And, in turn, these bank loans fund the creation of real assets in the economy, which themselves are also not particularly liquid. Of course, banks are not the only institutions that facilitate maturity transformation. Many collective investment vehicles offer a degree of liquidity to investors, but invest in assets that are not particularly liquid. A mutual fund that invests in real estate is a good example of this. Another example of sorts is the listed equity market. Share investors hold equity claims over The term bank is used for simplicity, though in the Australian context this applies to authorised deposit-taking institutions, encompassing banks, building societies and credit unions. BIS central bankers’ speeches firms’ assets. Under a range of conditions, these claims can be traded for cash at relatively short notice, even though the underlying assets are not particularly liquid. So, in a sense, both these examples share a similarity with bank deposits. Both are ways of giving savers relatively liquid claims on what are often intrinsically illiquid assets. There is, however, at least one very important difference. And that is that the bank promises to pay back the deposit in full. In contrast, in the other two examples, there is no such promise and the value of the investment moves up and down with the performance of the underlying assets. For bank deposits (and other short-term bank liabilities), this combination of maturity transformation and the promise to redeem at par sets up a potentially unstable situation. You can think of there being two possible states of the world. In the first – and usual – state, depositors have confidence that the bank is able to meet its liabilities and everybody is happy. In the second, there are concerns about the ability of the bank to meet its promise to repay in full and on demand, and depositors seek to withdraw their funds. Under some circumstances, this may force the bank to liquefy its assets, potentially at fire-sale prices, which can then worsen the bank’s financial position. A fire-sale in one class of assets can also cause stress to be transmitted across the system, with liquidity drying up in other asset classes amid a general rise in uncertainty. These risks are more than just theoretical possibilities. We saw these dynamics play out in a number of countries during the financial crisis in 2008. We saw some bank runs and, more importantly, runs by holders of short-term bank paper. We saw institutions trying to sell assets in a hurry, sometimes at substantial discounts to their earlier prices. And we saw markets freeze. In Australia, fortunately, we did not experience the severe problems witnessed elsewhere. However, when global markets froze, the Australian banks, like banks right around the world, could not access those markets. And while we had no high-profile depositor runs, we did see a general increase in nervousness by depositors, resulting in a significant lift in the demand for banknotes (Graph 1). 2 Both these issues were ultimately addressed with a public-policy intervention during the peak of the crisis in October 2008. The first was with the government being prepared to guarantee bank wholesale funding for a fee. And the second was an enhancement of depositor protection arrangements through a guarantee of bank deposits of up to $1 million. These actions followed similar steps to reassure investors and depositors in a number of other countries. This whole experience, both in Australia and elsewhere, has rightly shone the spotlight on the risks associated with maturity transformation. Prior to the crisis, many people were working under the implicit assumption that markets would always remain open and that financial assets could always be traded at reasonable prices. This assumption turned out to be incorrect. And, in response, it is entirely appropriate that stronger and more resilient arrangements be put in place. The various efforts have focused on two main areas. The first is strengthening bank balance sheets by increasing the amount and quality of capital in the banking system. By doing so, investors should have greater confidence that banks will be able to meet their liabilities under a broad range of adverse scenarios. The Australian banking system is part of this global trend to higher and better quality capital, with an increase in common equity lifting the aggregate capital ratio from around 10½ per cent prior to the crisis to around 12½ per cent at end 2014 (Graph 2). The recent capital announcements by some of the large banks will see this ratio rise further. See Cusbert and Rohling (2013). BIS central bankers’ speeches The second, and obvious, area of regulatory focus has been on liquidity management. Here, there have been two main initiatives. The first is the introduction of a Liquidity Coverage Ratio (LCR) which, from the start of this year, has required banks to hold enough high-quality liquid assets to meet a stress scenario that lasts for 30 days. 3 The challenge for the Australian banking system has been that the supply of such assets is limited due to the stock of government bonds on issue being small relative to the overall size of the financial system. To overcome this challenge, the RBA has provided banks with a Committed Liquidity Facility (CLF) under which it will make available sufficient liquidity (against eligible collateral) to address the shortfall in required holdings of high-quality liquid assets. The pricing of the CLF is aimed at replicating the cost of holding a sufficient volume of these assets, were they to be available in the marketplace. 4 APRA administers the decisions as to which banks access the program, and the maximum amount available to each bank. The second initiative is the Net Stable Funding Ratio (NSFR), which has a longer-term focus. It will establish a minimum amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one-year horizon. The new requirement here will not come into effect until January 2018. This increased focus on liquidity is clearly evident in the balance sheets of the Australian banks. On the assets side, holdings of liquid assets have increased substantially, after they declined for many years (Graph 3). Australian dollar denominated liquid assets are now equivalent to about 7 per cent of banks’ total assets, up from around 1 per cent in early 2008 (Graph 3). If the CLF is added in, the current figure is around 15 per cent. There have also been significant changes on the liabilities side of the balance sheet. The most noticeable has been a shift away from short-term wholesale debt towards deposits (Graph 4). In early 2008, deposits accounted for around 40 per cent of the Australian banks’ total funding. Today, that figure is just a little below 60 per cent. In part, this switch has been driven by the judgement that the risk of a run by depositors is less than the risk of a run by investors in short-term wholesale debt. To the extent that this judgement is correct, this switch has increased the effective maturity of banks’ liabilities in a stress event, even if it has not increased the contractual maturity. There has also been some lengthening in the average contractual maturity of the various types of liabilities. The share of deposits at the major banks with a maturity of less than three months has declined since 2007, although this share has increased a little more recently as competition for term deposits has waned (Graph 5). Similarly, there has been a noticeable increase in the maturity of banks’ other debt liabilities since 2007 (Graph 6). Of particular note, the share of other debt liabilities with maturities of less than three months has declined substantially. Taken as a whole, these measures have made the system more resilient. We are, though, yet to see how these various changes play out over the medium term. There is no doubt that they have increased the cost of financial intermediation somewhat. They have also increased the likelihood that such intermediation will take place outside the banking sector. After all, to some extent this is what was intended. So we need to keep a close eye on how the overall system responds and make sure that in addressing the very real risks associated with maturity transformation, that we don’t create a new set of risks. This is likely to be an ongoing challenge for us all. It is also important to point out that while the various measures have made the system more resilient, they do not guarantee stability. Because of the very nature of the business that See APRA (2013) and APRA (2014) for further details on the LCR. See Debelle (2014) for further details. BIS central bankers’ speeches banks undertake, they can still find themselves in a liquidity crisis. Here the role of the central bank acting as a lender of last resort is critically important. A central bank has the unique ability to effectively liquefy assets so that a bank can meet its liabilities (so long as its assets exceed those liabilities). Provided appropriate collateral is taken and appropriate haircuts are in place, it can do this without incurring material credit risk. In so doing, the central bank can provide society with an efficient and low-cost form of insurance against a liquidity crisis in the banking system. Indeed, it is a longstanding role of central banking to do exactly this. And it is a role that the RBA can, and is, prepared to play. Maturity transformation in the asset management industry But as I said before, banks are not the only institutions that undertake maturity transformation. Understandably, the sharper focus on liquidity risks has led to the question of whether the maturity transformation that is undertaken elsewhere in the system raises similar concerns. And the focus here has fallen very much on the asset management industry and its involvement in financial markets. 5 This focus reflects a couple of factors. The first is a structural one. And that is that the pool of assets managed by the asset management industry has grown substantially relative to the size of the economy. In Australia, for example, in the early 1990s the assets in managed funds were equivalent to around 40 per cent of GDP (Graph 7). Today, the figure is 125 per cent. And globally, asset managers are estimated to have around US$76 trillion in assets under management, equivalent to around 55 per cent of global banking assets. 6 So the industry is very large, and it is getting larger. Long-term forces, such as ageing populations and increased wealth, are important factors here, though the changes in the banking system that I have just spoken about have played a role more recently. The second factor has a more cyclical element to it. And that is a concern about the possible fallout from the search for yield that has resulted from the very low global interest rates. Money has flowed into collective investment vehicles that invest in a range of higher-yielding assets, including those in emerging markets. Many of these vehicles allow investors to redeem their funds at short notice, even though the underlying assets are not particularly liquid, and are likely to be even less liquid at a time when there are large-scale redemptions. This has occurred at a time when liquidity has declined in some markets, partly in response to a lower appetite for risk and tighter financial regulation. 7 This combination of developments raises the question of what might happen in stressed conditions. This increased focus on the asset management industry has seen a number of bodies either commission or issue reports on the industry over recent times. These bodies include the International Monetary Fund, the Financial Stability Board and the International Organization of Securities Commissions, and the US Financial Stability Oversight Council. 8 It has become quite a crowded field! The underlying concern is not that these vehicles will be unable to meet their obligations to their investors, but rather that they could serve to spread distress across the broader financial system. Two features of these vehicles, in particular, have drawn attention. The first A fuller discussion of these issues can be found in Price and Schwartz (2015). This estimate of assets under management, taken from IMF (2015), is based on the world’s top 500 asset managers at the end of 2013. It includes some double-counting due to cross-investment among asset managers. See Cheshire (2015). See FSB & IOSCO (2015), FSOC (2013) and IMF (2015). BIS central bankers’ speeches is the ease of redemptions even when the underlying assets are illiquid. And the second is the possible misalignment of incentives between the portfolio manager and the end investor, which could amplify shocks. These concerns have sparked a lively debate as to what, if anything, should be done. This is an area where Australia does have some relevant experience. In particular, in the past 25 years we have had two episodes where there have been significant runs on collective investment vehicles. The first was in the early 1990s and initially involved a run on mortgage trusts operated by Estate Mortgage. It followed a boom and subsequent emerging bust in the commercial property market. The run came to an end when redemptions were frozen by the National Companies and Securities Commission, a forerunner of ASIC. Subsequently, there were runs on a number of unlisted property trusts operated by other non-banks, with investors seeking to withdraw their funds prior to the periodic (and downward) reduction in unit prices. These runs eventually spread to trusts operated by banks. This led to fears that suspensions in these bank-operated trusts would spark a generalised loss of confidence in the banking system, which at the time was already under some strain. In response, the Australian Government announced a 12-month freeze on all redemptions from unlisted property trusts. 9 The second episode is much more recent and occurred during the peak of the financial crisis in 2008. Again, it involved property-related trusts. As uncertainty rose and conditions in property markets deteriorated, investors began to withdraw funds. These redemptions accelerated in mid-October 2008 after the announcement of the guarantee on bank deposits. In response, most mortgage trusts froze redemptions, with estimates of up to $30 billion being affected by freezes at that time. Subsequently, ASIC worked with the funds’ administrators to provide limited withdrawals for investors in hardship cases. Looking back at these experiences and the current international discussions, there are five brief observations that are perhaps useful to make. The first is the importance of investors understanding the nature of the liquidity promise that is being made. In normal conditions, many collective investment vehicles have the ability to offer a high degree of liquidity despite the bulk of the underlying assets being illiquid. But in stressed conditions, this ability can disappear quickly. This needs to be clearly understood by both investors and fund managers. This has not always been the case. The second is the benefit of clear rules around the process for freezing redemptions, including who is responsible for making these decisions. After the early 1990s experience, there was a change in legislation in this area. Under the current Corporations Act 2001, responsible entities must suspend withdrawals from a retail fund if “liquid assets” are less than 80 per cent of total assets, which should help to guard against fire-sales. 10 While in some other countries, responsible entities have a similar ability to freeze redemptions, it is not always compulsory for them to do so. The third is the importance of appropriate separation between bank-managed investment funds and the bank owners. APRA has prudential requirements for banks to address potential contagion risk between other members of the group. This includes clear disclosure that the group member is not a bank, and that the bank does not stand behind the group member – unless there is a formal legal agreement that is prominently disclosed. APRA also reserves the right to require an entity not to use a particular brand name if it would give rise This account is drawn from Gizycki and Lowe (2000). “Liquid assets” refers to assets including cash, bills, marketable securities or other property that the responsible entity reasonably considers able to be realised for its market value within the period provided for in the scheme’s constitution for satisfying withdrawal requests. BIS central bankers’ speeches to prudential concerns. Clear disclosure and branding reduces the probability that a redemption freeze in a bank-related investment fund would cause depositors to worry that their deposits will also be frozen. In Australia, the fund management arms of the major banks now largely have separate brands, but this is not always the case in other countries. The fourth observation is the importance of frequent updating of unit prices. The early 1990s experience illustrated the problems that can arise when there is a lag between changes in the value of the underlying assets and in unit prices, thereby creating an additional incentive to redeem in a falling market. Over time, there has been a move to much more frequent updating of prices in Australia, with funds now typically updating prices daily. The fifth and final observation is that, at least in these two examples, the runs and subsequent freezes did not lead to systemic problems in the financial system. In neither case was there a significant fire-sale of assets. The unit prices declined and investors experienced losses as the value of the underlying assets declined. This did not lead to stability issues in the broader system, although the freezes did cause hardship for some individual investors. So our own experience is that these types of disruptions in the asset management industry can be managed. However, the degree to which this lesson can be applied more broadly remains to be seen. Globally, there is considerable effort being devoted to understanding the nature of the risks in this area, including whether these risks are any different to those that would arise if investment portfolios were managed directly by the individual investors themselves, without the input of an asset manager. A related stream of work – which in some way parallels similar work for the banking industry – is to examine what role regulation should play in addressing the various risks and what role the central bank should play. Relevant issues here include: how prescriptive any liquidity regulations should be; what are the merits of alternatives to fund freezes, such as exit fees and liquidity gates; and what, if any, role should the central bank play when markets freeze and normally liquid assets cannot be traded. These are all difficult issues to deal with and perspectives range widely. I am sure that they will keep many of us busy over the years ahead. On that note, I would like to thank you for listening and I would be happy to answer any questions. BIS central bankers’ speeches References APRA (Australian Prudential Regulation Authority) (2013) “Implementing Basel III liquidity reforms in Australia”, APRA Discussion Paper, May. Available at http://www.apra.gov.au/adi/PrudentialFramework/Pages/Implementing-Basel-III-liquidityreforms-in-Australia-May-2013.aspx. APRA (2014), “APRA Finalises Implementation of Liquidity Coverage Ratio in Australia”, Media Release No 14.22, November. Available at http://www.apra.gov.au/MediaReleases/Pages/14_22.aspx. Cheshire J (2015), “Market Making in Bond Markets”, RBA Bulletin, March, pp 63–73. Cusbert T and Rohling T (2013), “Currency Demand during the Global Financial Crisis: Evidence from Australia”, RBA Research Discussion Paper No 2013–01. Debelle G (2014), “Liquidity”, Speech at the 27th Australasian Finance and Banking Conference, Sydney, 16 December. International Monetary Fund (2015), The Global Financial Stability Report, Chapter 3, April. Available at https://www.imf.org/External/Pubs/FT/GFSR/2015/01/index.htm. Financial Stability Board and International Organization of Securities Commissions (2015), Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions’, consultative document (2nd), March. Available at http://www.financialstabilityboard.org/wp-content/uploads/2nd-Con-Doc-on-NBNI-G-SIFImethodologies.pdf. Gizycki M and P Lowe (2000), “The Australian Financial System in the 1990s”, in D Gruen and S Shrestha (eds), The Australian Economy in the 1990s, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp 180–215. Price F and C Schwartz (2015), Recent Developments in Asset Management, RBA Bulletin, June, forthcoming. United States Financial Stability Oversight Council (FSOC) commissioned: Office of Financial Research (2013), “Asset Management and Financial Stability”, September. Available at http://financialresearch.gov/reports/files/ofr_asset_management_and_financial_stability.pdf. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches | reserve bank of australia | 2,015 | 5 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Economic Society of Australia Luncheon, Brisbane, 10 June 2015. | Glenn Stevens: Economic conditions and prospects – creating the upside Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Economic Society of Australia Luncheon, Brisbane, 10 June 2015. * * * I thank Elliott James for research assistance. Thank you for the invitation to speak in Brisbane once again. The last time I spoke with this group, in July 2013, the economy was estimated to be growing at about 2½ per cent. 1 Underlying inflation was 2¼–2½ per cent, consistent with the target of 2–3 per cent. Two years on, the economy is growing at just shy of 2½ per cent and underlying inflation is around 2¼–2½ per cent, consistent with the target. In some respects, then, it might seem that not much has changed. In fact a number of important developments have occurred during that period, some as anticipated and some not. Overall, the fact that not much has changed is disappointing: the economy has not picked up speed as we had hoped. In this talk, I will make some observations about the global and domestic economies, and try to give some sense of what we have learned in the past couple of years. The global economy Two years ago, we judged Australia’s trading partner group to be growing at about its average pace of around 4 per cent. It was expected that during 2014 and 2015 growth in this group would pick up a bit, to a pace a little above average. In fact, growth for our trading partners has remained at about 4 per cent and is expected to stay there over the next couple of years. To be sure, 4 per cent growth is faster than growth for the world economy as a whole, which is more like 3¼ per cent. It has been to Australia’s advantage that we have a high exposure, for an advanced country, to the faster-growing Asian region. As an example, while the euro area is a significant trading partner for Australia, we were probably less affected than many countries in 2012 and 2013 when Europe lapsed back into recession. Two years ago, I noted that the economy of the euro area was still smaller than it was before the financial crisis. Regrettably, that remains true today. Europe is back on a growth path now, but it is still a fairly modest one, and it seems to require extraordinary settings of monetary policy to achieve even that. Growth has recently resumed in Japan after a dip in activity following the enactment of a tax increase last year. Japanese growth rates remain pretty modest, though since Japan has a declining population, they look better on a per capita basis. The full implementation of the socalled “third arrow” of structural reform could be expected, if it occurs, to lift growth per head further over the long run. Growth is proceeding at a reasonable clip in the rest of Asia, though as I noted two years ago, in more than a few countries it has not been possible to restore the pre-crisis growth rates. And the growth that has been achieved has been accompanied in a number of cases With subsequent data revisions the growth rates in mid 2013 look a little lower now. BIS central bankers’ speeches by a sizeable increase in debt owed by households, firms or both. How big a vulnerability this will turn out to be under different financial conditions and/or lower growth we cannot yet know. While it has been to our advantage to have a lesser exposure to Europe than many other countries, the flipside is a much greater exposure to China. That means we will be more sensitive to fluctuations in China’s performance than other countries. This is not a new point; I said as much about five years ago. 2 But it is perhaps more concrete now, given that China’s growth has slowed appreciably over the past few years. The moderation in 2014 was more or less as China’s policymakers intended. The further moderation seen over the past six months or so may have been a little more than intended. Chinese policy has been responding to that outcome as you would expect: interest rates are declining, and some selected restraints on credit are being eased. Stepping back from the ebb and flow of short-run data, the big point is that China’s policymakers are attempting two major transitions. One is towards more consumption-driven growth, as opposed to investment and export-led growth. This is necessary because a continental-sized economy such as China cannot rely on the rest of the world absorbing rapid growth in its output. The second, related transition is towards a more robust financial structure, which is necessary because the prevailing structure has too many risky aspects. Both these transitions are necessary, but both remain works in progress. How they will play out is unavoidably a source of uncertainty. What does seem fairly clear is that the pace of growth in demand for commodities like iron ore will be lower in future than in the past five years, even as supply continues to increase. Thus far much of the additional supply has been Australian ore, though it is apparent that at least some of the future increase in supply will be from other countries. Perhaps it is not surprising, then, that Australian discussion of the Chinese economy has been through the prism of the iron ore price – these days subject to daily monitoring. A few months ago, it almost seemed as though the price of iron ore might, in terms of attention given, eclipse that other price on which Australians focus with a passion, namely the price of a house. But of late house prices seem to have regained their pre-eminent place in our national psyche! Turning away from China, it is quite significant that there is a good deal more optimism now in the United States. The rate of unemployment has fallen considerably and growth in wages has begun to increase. There was a weak March quarter result for growth in output, which most observers attribute to temporary factors, though it remains to be seen just how robust the return to growth has been since. The significance of a healthier US economy is two-fold. One element is that the expectations of many business people around the world, including in Australia, still tend to take a cue from the tone of US business. The second is that, at some point, US monetary policy will begin to adjust to improved conditions. That will be a very gradual process, but at this stage, indications still seem to be that the US Federal Reserve will begin the process some time this year. It is reasonable to hope that this change in course can be accomplished without serious disruption to financial markets, but we cannot be certain of that. Countries receiving crossborder capital flows have generally sought to strengthen their economic and financial fundamentals since the “taper tantrum” of mid 2013. The fact that the Fed has signalled as clearly as possible the way it thinks about these issues should also help reduce instability. On the other hand, “guidance” is no guarantee of smooth sailing. Moreover, we stand today at a highly unusual juncture. We see a combination of remarkably low yields on financial See ‘The Challenge of Prosperity’, Address to the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, November 2010. BIS central bankers’ speeches assets, compressed risk premia and diverging outlooks for monetary policy across the major jurisdictions. It is a complex picture for both market participants and policymakers. Recently, we have seen some large and abrupt movements in currencies, commodity prices and even sovereign bond rates. While to some extent this is a normalisation after a period of unusually subdued volatility, these movements may also be signalling that a degree of underlying fragility has built up over the long period of “search for yield”. Such dynamics bear watching. The Australian economy In Australia, recent growth in the economy has not been as strong as we want. Of course, what we are witnessing is not an economy heading along the course of a normal economic cycle, but a complex and rather lengthy adjustment both to the once-in-a-century cycle in our terms of trade and an earlier increase in household leverage. During the late 1990s and early 2000s, very confident households spent and borrowed more, and saved less, in the process extending their balance sheets. That process started to fade in about 2006 and then finished more abruptly when the financial crisis hit. But by then the run-up in resources prices was imparting a very large stimulus to the economy and allowed for solid growth to continue at a time when most other countries were still feeling the aftermath of the financial crisis. But now most of the capital spending that was needed to lift the output of the mining sector has been completed, at least for the production of iron ore. Some very large LNG projects are still underway, but as those projects and others draw to a close, the decline in mining investment that is already underway will continue (and perhaps accelerate). The latest edition of the Australian National Accounts, released last week, shows the picture. The quarterly growth figure was stronger than what had been embodied in our forecasts in the May Statement on Monetary Policy, though that comes after a weaker-than-expected outcome in the previous quarter. Some of the strength resulted from unusually high export shipments of resources, which were less disrupted by weather conditions in the “cyclone season” than has often been the case in the past. Indications are that this pace of growth wasn’t repeated in the June quarter, when shipments of coal in particular were affected by weather disruptions on the east coast. Taking the results over the past four quarters, growth was “below trend”. Export volume growth contributed strongly, while domestic final demand increased by a bit under 1 per cent, which is quite a weak result. Housing construction rose strongly, and consumer spending over the year rose by more than real household income (that is, the saving rate fell). Both these results owe a good deal to low interest rates and rising asset values. But other components of demand were weak. Business investment fell substantially, with mining investment falling quickly and, as best we can tell, non-mining capital spending also weak. Public final spending didn’t grow at all. Public investment spending fell by 8 per cent over the past year. Overall, these outcomes are weaker than what, two years ago, we expected would be happening by now. Back then, the two-year-ahead forecast was for annual GDP growth to be in a range of 2½ to 4 per cent by mid 2015. The width of that range reflected the normal size of error margins, coupled with the inevitable uncertainty about the timing of when some components of demand outside of mining might strengthen, and the judgement that if accommodative monetary policy really was held in place for several years (which was a key assumption behind those forecasts), activity could at some point start to pick up quite quickly. It will be three months before we get the national accounts data for the June quarter, but at this point, with three of the four quarters available for the year to June 2015, it would appear that the outcome will be either right at the bottom of the range predicted two years ago or, more likely, a bit below it. BIS central bankers’ speeches Of course, forecasts are hardly more than educated guesswork and two-year-ahead forecasts are even less reliable. That there are inevitably forecast errors is neither surprising nor new, and it is not any more concerning per se now than it always has been. This is far from the biggest forecast error I’ve seen over my three decades in this game. But it is nonetheless useful to see what we can learn from those errors. The following points are prominent: • The terms of trade, which two years ago were assumed to fall, have in fact fallen further – they are about 12 per cent lower than the assumed path. That means national income is lower, which means spending power is lower. • The exchange rate, which at that time was above parity against the US dollar, and was assumed to stay there, is now about 25 per cent lower. It has moved in the same direction as the terms of trade, which is normal. • The lower exchange rate has helped to produce a contribution to growth from “net exports” much greater than earlier forecast, while that from domestic demand has been much weaker. The latter is mainly spread across non-mining business investment and weaker government spending, together with softer consumption on account of lower incomes. One thing which is not very different from the forecast from two years ago is that mining sector capital spending is falling sharply. • Because the net effect of the above factors is that GDP growth has been on the weaker side of expectations, the unemployment rate is about half a percentage point higher than forecast two years ago. Consistent with that, growth in wages is, as you would expect, lower than forecast. • Headline inflation is lower than forecast, largely because of the recent fall in oil prices. Underlying inflation is within the 2–3 per cent range that had been forecast. Again, the depreciation of the exchange rate has been a factor here. • The cash rate is 75 basis points lower than assumed two years ago, as monetary policy has used the room provided by contained inflation to try to do more to help growth. Lending rates have fallen on average by about 100 basis points over that period. This has produced a stronger result for housing construction than forecast and will also have contributed to the rise in dwelling prices. In summary, the economy has in several important respects followed a different track from the one expected a couple of years ago. That is partly because conditions in the world economy were different from what had been expected and partly because several domestic factors were different. Some in-built responses have been in evidence. For example the decline in the exchange rate, even if not by as much as we might have expected, has had the effect of supporting growth and keeping inflation from falling as much as it might have done. And, of course, monetary policy has also responded to the evolving situation, consistent with the Reserve Bank’s mandate. These responses have had the effect of lessening the extent to which growth and inflation have differed from the outcomes expected two years ago, but haven’t managed to eliminate those differences entirely, at least in the case of output growth. The slowing in wage growth in response to soft labour market conditions has also undoubtedly helped to hold employment up. In fact wage growth appears to be somewhat lower than previous relationships between wages and unemployment would suggest. This may be a sign of increased price flexibility in the labour market and could help to explain why employment recently has looked a little higher relative to estimated GDP than might have been expected. These hypotheses can be advanced only tentatively, though, until we have more data. BIS central bankers’ speeches Looking ahead, the most recent forecasts suggest that growth rates will be similar to those we have observed recently for a while yet. Residential investment will reach new highs over the period ahead. Household consumption is expected to record moderate growth. With national income growth reduced by a falling terms of trade, this requires a modest decline in the saving rate. It doesn’t seem reasonable to expect much more from consumption growth than that. Resources sector investment has a good deal further to fall yet over the next two years. Other areas of investment seem very low and while I would have expected that by now these would have been showing signs of strengthening, the most recent indications are for, if anything, a weakening over the year ahead. Public final spending has not been growing and fiscal consolidation still has some way to run. Under the current macroeconomic conditions, it would seem inappropriate for governments to seek additional restraint here in the near term. Inflation is likely to remain low. Growth in labour costs is very low and some of the forces that were pushing up certain administered prices have started to reverse. So even if the exchange rate were to fall further, which in my view it needs to, we seem unlikely to have a problem with excessive inflation. Putting all that together, as things stand, the economy could do with some more demand growth over the next couple of years. Of course, these are forecasts. They might be wrong. In fact, they will be wrong, in some dimension or other. Our published material goes to some lengths to articulate a range of “risks”. It is easy to think of “downside” ones in the current mood of determined pessimism. But it is not entirely impossible to think of upside ones as well. A further fall in the exchange rate, which is not assumed in the forecasts, would add both to growth and prices. If one thinks that such a decline at some point is likely, that constitutes an “upside” risk. Of course, the list of countries that would prefer a lower exchange rate is a long one and we can’t all have it. That being so, we might give some thought to trying to create some upside risks to the growth outlook through policy initiatives. The Reserve Bank will remain attuned to what it can do, consistent with the various elements of its mandate – including price stability, full employment and financial stability. We remain open to the possibility of further policy easing, if that is, on balance, beneficial for sustainable growth. The temptation, of course, is to presume outcomes can be fine-tuned by policy settings and that we can simply dial up more or less demand in short order to avoid deviations from some ideal path. Reality is inevitably more messy than that and has not always been kind to such fine-tuning notions. As it is, some observers think monetary policy has done too little, while others think it already has done way too much. I think it has been about right for the circumstances. But the bigger point is that monetary policy alone can’t deliver everything we need and expecting too much from it can lead, in time, too much bigger problems. Much of the effect of monetary policy comes through the spending, borrowing and saving decisions of households. There isn’t much cause from research, or from current data, to expect a direct impact on business investment. But of all the three broad sectors – households, government and corporations – it is households that probably have the least scope to expand their balance sheets to drive spending. That’s because they already did that a decade or more ago. Their debt burden, while being well serviced and with low arrears rates, is already high. It is for this reason that I have previously noted some reservations about how much monetary policy can be expected to do to boost growth with lower and lower interest rates. It is not that monetary policy is entirely powerless, but its marginal effect may be smaller, and the associated risks greater, the lower interest rates go from already very low levels. I think everyone can see that. BIS central bankers’ speeches If I am correct about this, it really is very important that other policies coalesce around a narrative for growth. In this regard, I think the Government is on the right track in not seeking to compensate for lower revenue growth by cutting spending further in the short run. Of course, some resolution of long-run budget trends is still going to be needed to sustain confidence and that will not be an easy conversation. Meanwhile, as often remarked, infrastructure spending has a role to play in sustaining growth and also in generating confidence. I am doubtful of our capacity to deploy this sort of spending as a short-term countercyclical device. The evidence of history is that it takes too long to start and then too long to stop. But it would be confidence-enhancing if there was an agreed story about a long-term pipeline of infrastructure projects, surrounded by appropriate governance on project selection, risk-sharing between public and private sectors at varying stages of production and ownership, and appropriate pricing for use of the finished product. The suppliers would feel it was worth their while to improve their offering if projects were not just one-offs. The financial sector would be attracted to the opportunities for financing and asset ownership. The real economy would benefit from the steady pipeline of construction work – as opposed to a boom and bust. It would also benefit from confidence about improved efficiency of logistics over time resulting from the better infrastructure. Amenity would be improved for millions of ordinary citizens in their daily lives. We could unleash large potential benefits that at present are not available because of congestion in our transportation networks. The impediments to this outcome are not financial. The funding would be available, with long term interest rates the lowest we have ever seen or are likely to. (And it is perfectly sensible for some public debt to be used to fund infrastructure that will earn a return. That is not the same as borrowing to pay pensions or public servants.) The impediments are in our decisionmaking processes and, it seems, in our inability to find political agreement on how to proceed. Physical infrastructure is, of course, only part of what we need. The confidence-enhancing narrative needs to extend to skills, education, technology, the ability and freedom to respond to incentives, the ability to adapt and the willingness to take on risk. It is in these areas too, where there are various initiatives in place or planned, but which often do not get enough attention, that we need to create a positive dynamic of confidence, innovation and investment. That is the upside we need to create. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 6 |
Public lecture by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian National University, Canberra, 15 June 2015. | Christopher Kent: Monetary policy transmission – what’s known and what’s changed Public lecture by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian National University, Canberra, 15 June 2015. * * * Accompanying charts can be found on the Reserve Bank of Australia’s website. I thank Laura Berger-Thomson, Adam Cagliarini, Gianni La Cava and Matthew Read for excellent suggestions and assistance in preparing these remarks. 1. Introduction I’d like to thank Rohan Pitchford and Martin Richardson for organising this event. It’s great to be back at the ANU, where almost 30 years ago I was embarking on my study of botany just across campus, with some economics on the side for good measure. It was my dislike of compulsory chemistry classes led me down that side path. Tonight I want to talk about the effects of monetary policy on the economy. Interest rates have been at very low levels for some time. Yet economic growth is below trend, the unemployment rate is relatively high and domestic inflationary pressures are well contained. This is expected to remain the case for a time. It’s natural then to ask whether monetary policy is less effective than in the past. Almost 20 years ago, Stephen Grenville, who was in my current role at the time, gave a comprehensive account of what we knew and didn’t know about the transmission of monetary policy in Australia. 1 The structure of the economy has changed since then in ways that may have altered the transmission mechanism. So it is timely on two counts to consider how the monetary policy transmission mechanism is operating in the current environment. 2. How monetary policy works (in theory) 2.1 Overview of the transmission mechanism In responding to cyclical developments and inflation pressures, monetary policy has a significant influence on aggregate demand and inflation. The transmission of interest rates through the economy can be roughly described as follows. I’ll focus on an easing of monetary policy. 1. The Reserve Bank lowers the overnight cash rate. 2. Financial markets update expectations about the future path of cash rates and the structure of deposit and lending rates are quickly altered. 3. Over time, households and firms respond to lower interest rates by increasing their demand for credit, reducing their saving and increasing their (current) demand for goods, services and assets (such as housing and equities). 4. Other things equal, rising demand increases the prices of non-tradable goods and services. The price-setting behaviour of firms depends on demand conditions and Grenville S (1995), “The Monetary Policy Transmission Process: What Do We Know? (And What Don't We Know?)”, Talk to Australian Business Economists, Sydney, 28 August. BIS central bankers’ speeches the cost of inputs, including of labour. Higher aggregate demand leads to increased labour demand and a rise in wages. The transmission mechanism depends crucially on how monetary policy affects households’ and firms’ expectations. Expectations about the future path of the cash rate will affect financial market prices and returns, asset prices and the expected prices of goods, services and factors of production (including labour). Expectations of more persistent changes in the cash rate will have larger effects. The extent to which lower interest rates lead to extra demand will depend on how households and businesses alter their behaviour regarding borrowing and investing, as well as consuming and saving. These responses are often described as occurring via a number of different channels. 2.2 How interest rates affect demand – various channels The exchange rate channel is one way in which interest rates affect demand. Lower interest rates contribute to an exchange rate depreciation by reducing returns to, and hence the demand for, domestic assets relative to foreign currency-denominated assets. A depreciation increases the prices of foreign products relative to domestic products. This leads to a switching of demand towards domestically produced goods and services. (A lower exchange rate also leads directly to an increase in import prices.) Many macroeconomic models emphasise intertemporal substitution as the primary transmission channel. Households and businesses make decisions about whether to save more or less now so as to spend more or less later. Lower interest rates provide less reward for saving, thereby encouraging more expenditure in the near term (and less further out). Decreases in interest rates will boost asset prices, which can have a number of effects. First, it boosts investment in housing, equipment and other capital goods as it becomes less expensive to build than to buy (this is likely to be important, although empirical evidence of the relevance of the ‘q-ratio’ is weak). Second, households typically respond to an increase in their net worth by consuming a little more at each point in time. This is known as the wealth channel, which appears important in the Australian context. The balance sheet channel is closely related. Rising net worth makes it easier to borrow, with higher collateral values making lending a less risky proposition. The cash-flow channel appears to be an important part of the transmission mechanism in Australia. Changes in interest rates affect households’ and businesses’ cash flows. If they face liquidity or borrowing constraints, an increase in cash flows will typically lead to more spending. 2 For example, a decrease in interest rates lowers interest payments for households with variable-rate mortgages, leaving them with more disposable income to spend. At the same time, cash flows will be lower than otherwise for those with interestearning assets and they may choose to restrict their spending. Notwithstanding this latter effect, decreases in interest rates can be expected to increase demand through this channel. This reflects the fact that the household sector in Australia is a net borrower, by which I mean that its interest bearing liabilities are greater than its interest-earning assets. 3 Moreover, it seems plausible that marginal propensities to spend are generally higher for debtors (who may face credit constraints) than for creditors. Unconstrained households can adjust their borrowing so as to smooth their consumption in the face of temporary fluctuations in income. In a closed economy context (with no public sector), a net debt position of the household sector would imply that the corporate sector is lending to households. In such a world, lower interest rates would benefit households with debt, but at the expense of lower payments to households that own the corporate sector. In this case, the cash-flow channel would depend on differences in marginal propensities to consume across different types of households. BIS central bankers’ speeches That’s a rough sketch of the theory of the transmission mechanism. What can we say about it in practice and how might it have changed over time? 3. Estimates of the overall effect of monetary policy It is difficult enough to estimate the strength of the monetary policy transmission mechanism in terms of its effect on the economy overall. It is harder still to separately identify the strength of each of the various channels. A key challenge is disentangling the effect of monetary policy from other influences, such as foreign developments or changes in fiscal policy. This requires models that simultaneously account for these and other forces. There are a wide range of model estimates from which to choose, each capturing different aspects of the ways in which the world works in reality. For illustrative purposes, let me mention just one set of recent estimates provided by some of my colleagues using a socalled Dynamic Stochastic General Equilibrium (DSGE) model. 4 Consider the estimated effects of a decrease in the cash rate of 100 basis points. This will lead GDP to be higher than otherwise by between about ½ and ¾ of a percentage point over the course of two years (Graph 1). Inflation is estimated to rise by somewhat less than ¼ percentage point per annum over 2–3 years. These estimates are close to those of other models. 5 Estimates from this DSGE model tentatively suggest that the overall effect of monetary policy has not changed significantly in recent years. In particular, estimates of the ‘endogenous’ relationships in the model based on data up to 2008 (after which interest rates have been notably lower) are about the same as estimates based on data to the present day. This suggests that the period of below-trend growth in GDP over the past few years may not reflect a change in the monetary policy transmission mechanism. Rather, the model attributes below-trend growth to sizeable exogenous forces or shocks. The sharp fall in commodity prices has played an important role of late. Also, weakness in private investment – beyond that which can be explained by subdued domestic demand and falling commodity prices – has made a sizeable contribution to below-trend growth. The model also suggests that consumption growth has been a bit weaker than in the past. These estimates provide some tentative evidence that the overall effect of monetary policy is neither more nor less effective than in the past. However, it may be that it’s too early to identify any structural change with the data to hand. Alternatively, the effect of monetary policy on overall activity and inflation might be close to its historical average, but this could mask changes in its effects across different parts of the economy or variation in the relative strength of the different channels from one episode to the next. 4. Estimates of some channels of monetary policy I’ll consider this possibility by looking more closely at the behaviour of dwelling construction and household consumption. I’ll leave to one side the effects of monetary policy on business See Rees D, P Smith and J Hall (2015), “A Multi-sector Model of the Australian Economy ,” RBA Research Discussion Paper No 2015-07. This paper does not explicitly model all of the various channels of monetary policy referred to above but the effect of a change in monetary policy on activity and inflation can loosely be interpreted as the operation of all of the relevant channels on these variables. For example, see Dungey M and A Pagan (2000), ‘A Structural VAR Model of the Australian Economy’, Economic Record, 76(235), pp 321–342; Berkelmans L (2005), ‘Credit and Monetary Policy: An Australian SVAR’, RBA Research Discussion Paper No 2005–06; Bjørnland H (2009), ‘Monetary Policy and Exchange Rate Overshooting: Dornbusch Was Right After All’, Journal of International Economics, 79(1), pp 64–77; and Jääskelä J and K Nimark (2011), ‘A Medium-scale New Keynesian Open Economy Model of Australia’, Economic Record, 87(276), pp 11–36. BIS central bankers’ speeches investment and external trade. 6 I’d note though that a further rise in the growth rate of household expenditure should contribute, in time, to a pick-up in non-mining business investment. So too would a further depreciation of the exchange rate, which would raise the demand for domestic production. We have argued that a further exchange rate depreciation appears likely and necessary, particularly given the large declines in commodity prices this year. 4.1 Responsiveness of dwelling construction Dwelling construction is typically the most interest-rate sensitive component of expenditure in the Australian economy. It is growing strongly in response to low interest rates, rising by about 9 per cent over the past year (Graph 2). The results of a standard ‘single-equation’ reduced-form model suggest that the response (to date) of residential building approvals to lower interest rates and higher housing prices is broadly consistent with historical experience. 7 Although the behaviour of construction investment over the past few years is not unusual, it is possible that with a period of very low rates there will be some limit as to how much demand for dwelling construction can be brought forward from the future. It is also possible that a period of very low interest rates will eventually lead to higher inflation for land and construction work, as is normally required to bring forth more supply of a particular good or service. These pressures might arise from a depletion of suitable land available for development or a need to attract more developers and workers into the industry. In such circumstances, any further increases in construction demand would tend to push up prices of existing and new dwellings. This could occur via increases in land prices, construction wages, developers’ margins or some combination of all three. The direct effect of additional demand for construction on economic activity would be less than in the case of ample spare capacity. But such a situation would still provide support to aggregate demand in other ways, including via the operation of the balance-sheet and wealth channels. There is evidence of some tightening in supply in pockets of the country. In some cities, stocks of unsold lots suitable for development appear to be unusually low (Graph 3). Shortages are most evident in Sydney, where greenfield land releases have not kept pace with recent strong demand. Also, some of the Bank’s liaison contacts are concerned that the stock of suitable sites for apartment developments in Sydney has been depleted in the past few years. There is little evidence of labour supply constraints outside a few trades and professional roles. However, inflation of building material prices has risen and the Bank’s liaison suggests that some builders have increased margins over the past year or so. Consistent with this, inflation in new dwelling costs has risen to be almost 2 percentage points above its average over the inflation-targeting period; although, it is still below that seen when dwelling construction was strong in the early 2000s. Despite the potential emergence of some constraints affecting the supply of new dwellings in pockets of the country, there appears to be scope for strong growth in new dwelling I’ve said quite a bit about the difficulty of modelling business investment. See Kent C (2014), ‘Non-mining Business Investment – Where to from Here?’, Address to the Bloomberg Summit, Sydney, 16 September. It is often difficult to find a significant empirical relationship between interest rates and business investment. For a discussion of how businesses respond to changes in interest rates see Lane K and T Rosewall (2015), ‘Firms’ Investment Decisions and Interest Rates’, RBA Bulletin, June, forthcoming. It appears that there might be a slightly longer delay between the time approvals are granted and the construction of housing than in the past. This is likely to reflect the larger share of higher-density dwellings, which take longer to complete than detached dwellings. For more information on this point, see RBA (2015), ‘Box C: The Cycle in Dwelling Investment’, Statement on Monetary Policy, May, pp 43– 45. BIS central bankers’ speeches construction in other parts of the country. Moreover, alterations and additions activity could pick up. This used to account for about 45 per cent of total dwelling construction, but has declined over the past few years, despite lower interest rates and the sizeable increase in dwelling prices. In short, there are some signs of tightening supply conditions in pockets of the country, but dwelling construction overall is responding to low interest rates much as it always has done. 4.2 Consumption and the behaviour of borrowers and savers What about the effect of low interest rates on household consumption? This can be modelled in a simple way by linking household consumption to disposable income and household wealth. In such a model, lower interest rates affect consumption indirectly by increasing household disposable income and boosting both housing and equity prices. 8 This simple model (like the DSGE model results I discussed) provides some tentative evidence that consumption growth has been a bit weaker over recent years than suggested by historical experience. Much of that history, however, captures the period of adjustment to easier access to credit from the early 1990s to the mid 2000s. At that time, household indebtedness increased substantially and the saving ratio declined to be well below earlier norms (Graph 4). 9 So in a way, the more recent experience could be regarded as the more standard response. Indeed, the behaviour of late appears more sustainable than that of the previous episode. 10 One aspect of this change in behaviour is evident in households injecting equity into the housing stock over recent years. That is, their net new spending on housing assets has exceeded their borrowing secured over housing. This stands in stark contrast to the period of strong housing market conditions in the first half of the 2000s, which saw households withdrawing housing equity to help finance their consumption (Graph 5). 11 As I just mentioned, the experience of recent years is characterised by slightly lower growth of consumption than might have been expected. However, the responsiveness of consumption to disposable incomes and wealth does not appear to have changed, at least in a statistically significant way. There are two possible explanations for this observation. First, the growth of consumption of late could be affected by factors other than the stance of monetary policy. Second, it may be that the strength of the various monetary policy transmissions channels affecting consumption has changed, but in ways that are difficult to identify using models of aggregate household behaviour. Although it is hard to be definitive, my sense is that both these explanations are likely to be true. Estimates of wealth effects tend to differ somewhat based on the exact data and methodology used in their estimation. Previous work by Bank staff suggests that households consume between 3 and 4 cents out of every extra dollar of housing wealth. For examples, see Dvornak N and M Kohler (2003), ‘Housing Wealth, Stock Market Wealth and Consumption: A Panel Analysis for Australia’, RBA Research Discussion Paper No 2003–07 and Windsor C, J Jääskelä and R Finlay (2013), ‘Home Prices and Household Spending’, RBA Research Discussion Paper No 2013–04. See RBA (2014), Submission to the Financial System Inquiry, March, Chapter 2. See Stevens G (2013), ‘Economic Policy after the Booms’, Address to The Anika Foundation Luncheon, Sydney, 30 July. For a description of housing equity withdrawal, see Schwartz C, T Hampton, C Lewis and D Norman (2006), ‘A Survey of Housing Equity Withdrawal and Injection in Australia’, RBA Research Discussion Paper No 2006–08. BIS central bankers’ speeches Let me start with changes affecting the cash-flow channel. Net interest payments of households are now more responsive to changes in interest rates than they were a decade or more ago (at least in the short term). To illustrate the magnitude of this, we can estimate the effects of a 100 basis point reduction in the cash rate on net interest payments (as a share of household disposable incomes; Graph 6). 12 There has been a noticeable increase in households’ holdings of interest-earning assets (such as bank deposits) over recent years (Graph 7). But despite this, a reduction in interest rates still lowers households’ net interest payments, and by much more than was the case in earlier decades. This larger response reflects the substantial increase in housing credit from the early 1990s to the mid 2000s. By itself, the greater responsiveness of net interest payments implies that the cash-flow channel should be stronger now than it was previously. Other things equal, we might have expected that the stronger effect of interest rates on the average household’s cash flows, and the operation of the other channels of monetary policy, would have encouraged a more noticeable rise in debt and a larger increase in current consumption in response to very low interest rates. Yet household indebtedness has been relatively stable for some years now (Graph 7 and Graph 9). While low interest rates may have helped to support consumption and debt, other forces appear to have been working in the opposite direction. Moreover, the response of consumption and indebtedness will depend on how different types of households are responding to these forces. Let me make this clearer with some examples. Some households may have revised down their expectations for income growth and may also be more uncertain about their incomes. This would be consistent with the substantial decline in wage growth and the rise in the unemployment rate over the past few years. 13 This could have caused some households to have become uncomfortable with the levels of debt that they had been carrying. Accordingly, many households may have decided to pay down their debts faster than they would have in a world of unchanged expectations about incomes, thereby contributing to a period of weaker consumption growth. In such an environment, lower interest rates help to facilitate ‘deleveraging’, hastening the time at which those households will feel more secure about their financial situation. There is evidence of many households behaving in this way. In particular, the rate of mortgage prepayments has increased as interest rates have fallen and more households are well ahead of their required schedule of repayments (Graph 8). 14, 15 Also, if we deduct funds held in mortgage offset accounts and ignore investor credit, we can see that the rest of household credit has declined by about 4 percentage points as a share of household disposable income since early 2010. This is consistent with a degree of deleveraging among some households, particularly when we consider that low interest rates This chart estimates the reaction of cash flows to the cash rate change within a month. Since a larger share of deposit rates are fixed than are loan rates, this will overstate the effect on cash flows over longer time horizons, though the extent of this bias has not necessarily changed over time in an obvious way. Jacobs D and A Rush (2015), ‘Why is Wage Growth So Low?’, RBA Bulletin, June, forthcoming. A lack of data means that we cannot make comparisons to earlier easing phases when indebtedness was lower. Another factor potentially muting the response of consumption to interest rate changes relates to banks’ processes for adjusting scheduled mortgage repayments following changes in lending rates. Some banks do not decrease scheduled mortgage repayments when interest rates decrease. This means that even though the interest component of the repayment has declined, the total repayment is the same, resulting in many borrowers automatically making excess principal repayments. See Thurner M-O and A Dwyer (2013), ‘Partial Mortgage Prepayments and Housing Credit Growth’, RBA Bulletin, September, pp 31–38. BIS central bankers’ speeches might otherwise have encouraged a general increase in this type of credit over that period (Graph 9). 16 What about those households that rely on interest-bearing assets? Their disposable incomes are lower than otherwise given the sizeable decline in interest rates. 17 Accordingly, such households may be reluctant to maintain consumption by either running down their pool of liquid assets, or accessing capital gains they may have enjoyed on any housing or equities that they hold. Such behaviour would contribute to the growth of aggregate consumption being less responsive to a decline in interest rates than in the past. Finally, let’s consider those households with some spare funds to invest. The very low level of interest rates may have prompted such households to search for yield. Many of these households have combined those spare funds with new debt to purchase housing for the purposes of investment. Indeed, the strong growth of investor housing loans has driven the growth in household debt (as a share of disposable incomes) over recent years and contributed to a rise in both housing prices and dwelling construction. While this may not directly contribute to a rise in consumption of households undertaking the investment, it will support overall economic activity nonetheless. Conclusions Monetary policy is clearly working to support demand, although it is working against some strong headwinds. These include the significant decline in mining investment, fiscal consolidation at state and federal levels and the exchange rate, which continues to offer less assistance than would normally be expected in achieving balanced growth in the economy. Model estimates that control for these and other forces provide tentative evidence that the monetary policy transmission mechanism, in aggregate, is about as effective as usual. However, it may be too early to pick up a statistically significant change using such models. As usual, dwelling construction is growing strongly in response to low interest rates, and this is making some contribution to the growth of aggregate demand and employment. It may be that in parts of the country, any further substantial increases in residential construction activity might run up against some supply constraints, putting further upward pressure on housing prices. As the Bank has noted for some time now, large increases of housing prices, if accompanied by strong growth of credit and a relaxation of lending standards, are a potential risk for economic stability. Accordingly, the Bank is working with other regulators to assess and contain such risks that may arise from the housing market. Consumption growth has picked up since 2013. But it is still a little weaker than suggested by historical experience. This may reflect a number of factors including some variation in the ways that the different channels of monetary policy are affecting households according to their stage in life. Some indebted households appear to be taking advantage of low interest rates to pay down their debts faster than has been the norm, perhaps in response to weaker prospects for income growth. Those relying on interest receipts may feel compelled to constrain their consumption in response to the relatively long period of very low interest rates. Meanwhile, the search for yield is no doubt playing a role in driving the strong growth of investor housing credit. This might provide some indirect support to aggregate demand, but this channel is not without risk. From mid 2010 to mid 2012, about half of the decline in the dashed line in Graph 9 owed to lower owneroccupier housing credit (net of offset accounts), but since then it has returned to about the same level as it was five years ago (as a share of disposable income). For further discussion of this issue, see Connolly E, F Fleming and J Jääskelä (2012), ‘Households’s Interestbearing Assets‘, RBA Bulletin, December, pp 23’32. BIS central bankers’ speeches In short, monetary policy is working. The transmission mechanism may have changed in some respects, and this could help to explain lower-than-expected growth of consumption and debt of late. But it is hard to be too definitive. To know more about this, it would be helpful to better understand the behaviours of different types of households using householdlevel data. To use a botanical analogy, to know more about a plant, it’s helpful to observe how its different types of cells work. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 6 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Launch of the Australian Centre for Financial Studies report on Financial Integration in the Asia Pacific, Sydney, 16 June 2015 | Guy Debelle: Remarks on financial integration in the Asia Pacific Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Launch of the Australian Centre for Financial Studies report on Financial Integration in the Asia Pacific, Sydney, 16 June 2015 * * * Thanks to Marc-Oliver Thurner and David Norman for their assistance. Accompanying charts can be found on the Reserve Bank of Australia’s website. It is a pleasure to speak at the launch of the Australian Centre for Financial Studies (ACFS) work on Financial Integration in the Asia Pacific. I have had some first hand experience on financial integration through the Asian Bond Fund (ABF) initiative, working with my fellow central bankers in Asia through EMEAP. In particular, in launching ABF2 and the Pan-Asian Index Fund (PAIF) around a decade ago, we got direct exposure to some of the impediments to financial integration in the region, both regulatory and tax. We worked together to reduce some of those impediments, which helped to pave the way for an expansion in cross-border fixed income investment in the region. I would like to talk about some issues that come to mind when thinking about financial integration. In doing so, my aim is to pose questions that the ACFS work might consider, without providing any answers. The first issue is about developments over the past decade or so, which show that financial integration is not a monotonic process. It is not always onwards and upwards. There was a reversal in some metrics of financial integration after 2008. In particular, cross-border banking flows declined steeply in 2008 and 2009, and have, in aggregate, continued to shrink until fairly recently. Interestingly, cross-border flows involving Chinese and Japanese banks have been increasing while those elsewhere, particularly in Europe, have been declining. We have seen that here in Australia, with lending by Chinese and Japanese banks into Australia growing quite rapidly (albeit from a low base), as lending from European banks has been declining (Graph 1). Some Chinese banks have obtained Australian banking licences while some European banks have given them up. In light of these developments, one question that is worth contemplating is whether there is such a thing as an optimal degree of financial integration? Can there be too much of it? The experience of the financial crisis shows that at least some forms of financial integration didn’t go too well. Relatedly, what is the most beneficial form of financial integration? Is it cross-border banking flows? And if so, should those flows be through a branch or a subsidiary, taking account of the varying regulatory environments that come with that choice? Are bank to bank flows more problematic than direct lending by foreign banks to domestic borrowers? The experience of cross-border banking is also replete with examples of the last-mover disadvantage. The general argument mounted in support of cross-border banking is that it allows a bank to profitably utilise its knowledge, systems and skills in a new market. But is that best done by partnering with an existing bank, or entering the market on your own? While there may be opportunities that arise with a better banking model, it can often be the case that all the good credits are taken. The local banks already have well-established relationships with the customers with the strong balance sheets and it may be quite difficult to wean them away, however attractive the proposition put to them. This can lead to the new entrant filling its book with the fish John West rejects. That’s not necessarily a bad thing, nor obviously unprofitable, but the credit quality is likely to be lower. BIS central bankers’ speeches Alternatively, are flows intermediated by markets more beneficial, whether in the form of bonds or equity? For many years, there has been a marked contrast in the financial structure of the US and most of the rest of the world. In the US, there is a considerably higher share of market-based intermediation, whereas in the rest of the world, including Australia and Asia, bank-based intermediation has the lion’s share of financing. One consequence of the regulatory reform program after the crisis is that it has tended to increase the cost of bank-intermediated finance. As a result, market intermediation is increasing, which will have implications for the future of financial integration in Asia. This is evident in the recent strong issuance of offshore bonds by Asian non-financial corporations. Much of this rise has been driven by Chinese issuers, which now account for about 40 per cent of the bond issuance by Asian non-financial corporations (Graph 2). However, borrowing from banks still represents the vast majority of debt of Asian nonfinancial corporations. Another question that arises is which of these forms of cross-border flows – banking or market-based – are more stable? This is an issue which gets a lot of attention in the Asian region and will once again come into sharp relief when the Fed raises its policy rate. The increase in cross-border flows into emerging markets over recent years, particularly in the Asian region, has contained a large amount of market-based finance. Asset managers have a much higher share of emerging Asia in their funds under management today than they did a decade ago. How stable are these flows likely to be in a more volatile environment? What is the behaviour of the investors who have allocated a higher share of their portfolio to emerging markets? How much of that increased share is a result of a search for higher yield which might reverse when yields in traditional developed markets increase? How much of it is a structural diversification into the emerging world as it has become a much larger share of the global economic and financial landscape? A major influence on the future path of financial integration in the Asia-Pacific region will be developments in Chinese financial markets. China is on a path of financial deregulation and capital account liberalisation. Almost no other country has managed this process without encountering significant problems. While China has endeavoured to learn the lessons from all the other countries that have gone down this path, including Australia, it will be a significant achievement if they are able to pull it off without encountering some problems. Investing in China’s domestic markets has become easier over the past year, with a range of new initiatives gradually opening the capital account, at this stage, primarily by allowing more portfolio flows between Hong Kong and the mainland. The new schemes expand the avenues for investing in China’s domestic debt and equity markets from the existing RQFII and QFII programs, which at the end of May accounted for around US$140 billion of foreign investment in China. The Shanghai-Hong Kong Stock Connect scheme, which started in November last year, is at about half its northbound capacity of around US$50 billion. A Shenzhen-Hong Kong Stock Connect is expected to be announced soon. The mutual recognition of funds agreement, effective from July, will allow fund managers registered in Hong Kong to offer investment fund products to mainland residents (and vice versa). From an Australian perspective, these avenues should provide an opportunity for Australian banks, asset managers and their clients to increase their exposure to the Chinese domestic financial market. Australian international portfolio investment has been growing strongly over recent years from around A$450 billion in 2010 to over A$750 billion at the end of 2014 (Graph 3). While the share of Asian bond investment has risen a little over that period, the share of investment in Asian equities has been largely steady. Both remain at well below 10 per cent of total portfolio investment in offshore markets. There would appear to be significant scope for further financial integration with the region. BIS central bankers’ speeches To conclude, the work by the ACFS is focussing on an area of significant importance today and one that will be important for a long time to come. There are many issues to discuss, a few of which I have highlighted here. The briefing paper is a promising start and I wish them well for the rest of the project. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 6 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Anika Foundation Luncheon, supported by Australian Business Economists and Macquarie Bank, Sydney, 22 July 2015. | Glenn Stevens: Issues in economic policy Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Anika Foundation Luncheon, supported by Australian Business Economists and Macquarie Bank, Sydney, 22 July 2015. * * * I thank Elliott James for research assistance. Thank you for coming out once again to support the Anika Foundation. 1 As a result of your generosity in past years, the Foundation is continuing to expand its activities, as you have heard from earlier presentations. The very efficient logistics for today were again provided by The Australian Business Economists. I also thank Macquarie Group for its financial support of today’s event. I will organise today’s remarks under four headings: • Negotiating turbulence • Accepting adjustment • Maintaining stability • Securing prosperity. Negotiating turbulence Until recently, we were living, at a global level, through a period of remarkably low volatility and skinny pricing for risk. There was bound to be some set of events with the potential to change that. Once again, some of them have been in Europe. After some months, difficult discussions between the Greek Government and its European partners reached an impasse and Greece was, as a result, unable to make a scheduled repayment to the IMF. The ensuing few weeks, during which the Greek authorities had no choice but to curtail access to the banking system, have been extremely difficult and surely quite damaging for the Greek economy. There has been progress towards a solution in recent days, though a huge amount of work remains ahead to put the Greek economy, and the whole European project, onto a stable footing. To date, though, the financial spillovers from the Greek situation have not been large. Spreads to German sovereign yields observed for debt issued by the governments of Spain, Portugal and Italy remain quite contained. At this stage, we do not see a market response that signals serious doubts about the ability of those countries to remain in the euro area. There could be little doubt about the willingness of their European partners and European institutions to support these countries in the event that market conditions took a serious turn for the worse – as they might have done, and still might, had/if “Grexit” occurred. The likely direct economic spillovers to the rest of Europe also seem fairly contained, since Greece is quite a small economy. Of course, things remain fluid. An unexpected turn of events – of which there have been many over time – could change the assessment above. Broader financial and economic impacts might be longer in coming and harder to predict. There are also important geo- See www.anikafoundation.com. BIS central bankers’ speeches strategic elements to the situation, which is one reason why nations outside Europe are taking such an interest. For our part, all we can do is watch and see what eventuates. Meanwhile, and of arguably greater relevance in our part of the world, China’s economy and financial system are going through a period of adjustment and uncertainty. Recently there have been some quite spectacular developments in the equity market. A rapid run-up in share prices – which more than doubled in the space of a year, far beyond any plausible prospective improvement in company earnings – turned to a slump in mid June to early July. Share prices remain well above their level of a year ago, but the speculative nature of the run-up, and the part played by an increase in leverage, has understandably made everyone a little nervous. The Chinese authorities have acted forcefully with some very wide-ranging interventions to stabilise the situation. The effect this will have on the Chinese economy is not clear, but may prove to be relatively small. Share prices have stabilised in recent days and authorities have been making financial conditions more accommodative. Households’ direct exposure to equity prices is relatively small, notwithstanding their large share of turnover. In addition, the rise in share prices was probably too short-lived for there to have been much in the way of positive wealth effects on spending. Other leveraged entities, such as banks and brokers, have shown little obvious sign of stress resulting from the developments in equity markets. It seems, on the basis of information available at present, that developments in the Chinese property markets and the broader financial sector are likely to be more important for the outlook. The economy had been showing signs of slowing, of course, in the first part of this year. But policies have been responding to this, and some of the recent economic data suggest they have been having a positive effect. Lastly on the international front, the likelihood still seems to be that US interest rates will begin to rise before the end of this year. This change, when it comes, will have been very well telegraphed. That being said, long-term yields in the United States and elsewhere are still very low, and risk premia compressed, albeit not so much as they were. Some turbulence may well occur as a result not of the first increase in US rates, but of investors trying to assess how soon subsequent increases might occur. But sooner or later we have to see a start to the process of adjusting these financial prices and I would expect Australian financial markets to be able to take all that in their stride. Accepting adjustment The Australian economy has been growing, but at a pace a bit below what we have traditionally thought of as average, as it adjusts to some pretty large changes in circumstances. The story of the phases of the “mining boom” is well known. Commodity prices rose massively and have since declined (though some prices remain pretty high compared with longer-run history). Investment spending followed suit – first it rose by about 5 to 6 percentage points of GDP, and now it is on its way back down. Finally, shipments of resources picked up, as the new capacity created by the investment became available. As an aside, unlike the situation posited some years ago in the United States, and notwithstanding the growth of services, the physical weight of Australia’s GDP has probably increased over the past decade. For iron ore and coal, annual tonnages being shipped from Australian mines have increased by more than half a billion tonnes since 2004. Growth in domestic demand, in contrast, is fairly subdued. Over the latest year for which we have data (to March 2015), final domestic spending rose by a bit under 1 per cent, as the fall in resources sector capital spending accelerated. Capital spending by other businesses has been weak too, while public demand was roughly unchanged over that year. BIS central bankers’ speeches The weakness in those areas is juxtaposed, as you know, with changing household behaviour. After a lengthy period during which consumer spending growth ran ahead of income growth, and leverage (measured as the ratio of debt to income) almost trebled, households changed course some time ago. To be sure, the rate of saving from current income has declined a little over the past couple of years, which is what is expected at a time of very low interest rates and positive wealth effects resulting from rising asset values. But it remains significantly higher than it was a decade ago. The types of saving rates we see now are more likely to be “normal” than those of a decade ago. Moreover, while some households (such as first home buyers or, perhaps increasingly the same thing, first home investors) are taking on more leverage, many others are reducing it. They are taking advantage of lower borrowing costs to repay mortgage debt ahead of the schedule in their debt contracts. Despite the lowest interest rates that any current borrower has ever seen, the pace of lending to households remains moderate. This is not a credit crunch – lenders are willing to lend and competition to do so is strong. Indeed, the prudential supervisor has been minded recently to issue some timely warnings about the need to maintain sound lending standards. Rather, the story is that households are being more prudent about debt and are holding more liquid assets. One measure of this is the size of “offset account” balances – bank deposits held to offset mortgage debt. These now amount to about $90 billion. When the housing credit data are adjusted for the increase in offset account balances, the rate of growth over the past year is put at about 6 per cent, as opposed to over 7 per cent as published. This may mean that the effect of easy monetary policy is to be somewhat lessened, at least for a time. Taking a medium-term perspective, though, the general strengthening of the balance sheet among many formerly more-indebted households has to be seen as a good thing. In the interim, the somewhat more restrained attitude to debt and spending by households, combined with a similar attitude by the government sector, has meant that there has not been quite enough domestic demand to achieve full employment, in the face of the fall in business investment. That is why we have felt that, on balance, a somewhat lower exchange rate was likely to be a part of the necessary adjustment. That adjustment seems to be occurring, with relatively little disruption, and is having an expansionary effect. Growth in services trade for example is picking up. The “net export contribution” of services trade over the past year, of around ½ percentage point of GDP, is about the same as the contribution from iron ore exports over that period. It is worth noting that business conditions as measured in surveys have tended to improve overall, outside the mining sector, over the past year or so. At the same time, the state of the labour market, while still somewhat subdued, appears to be better than we had expected three or six months ago. Employment growth has picked up noticeably, and hours worked have also increased. The rate of unemployment is unchanged from a year ago, whereas we had been thinking it might be a little higher than this by now, since growth in real GDP has been, according to the available statistics, below trend. Candidate explanations for this better-than-expected set of labour market outcomes include the following: • Perhaps there is statistical noise in the labour force data or maybe future observations or revisions will paint a different picture. It is worth noting here that recent information on Australian population growth suggests that the absolute growth of employment will be revised down somewhat, though this should not significantly affect labour market ratios like the unemployment rate or the employment-to-population ratio. • Perhaps output growth has been higher than the GDP data suggest, in which case upward revisions to those data would probably occur over time. BIS central bankers’ speeches • Perhaps below-trend output growth and trend employment growth can be reconciled in the form of the slower-than-expected growth of wages. • Perhaps trend output growth is lower than the 3 per cent or 3¼ per cent we have assumed for many years. That is, perhaps the growth we have seen is in fact closer to trend growth than we thought. Some or all of the above possibilities may be at work. Time will tell which ones, but a few observations may be worthwhile at this point. First, the economy is making the adjustments required, even if it is a bit slower than we would ideally have liked. Second, if the slow growth of wages has in fact been a significant saver of jobs, that would appear to indicate a degree of labour market flexibility in operation. Third, to the extent that the data are hinting that our assumptions about trend growth may need to be revisited, that will be worth some discussion. It need not be the case that per capita growth would be any lower, if the lower growth simply reflects slower population growth. So there may be few implications for living standards as measured by income per head. But if there are assumptions about absolute growth rates embedded in business or fiscal strategies, or retirement income plans, they would need to be re-examined. I suspect this will turn out to be an important discussion: what is Australia’s potential economic growth rate, per head, and why? And what do we want it to be? And, of course, what do we need to do to achieve our desired outcome? I return to that theme – securing prosperity – shortly. But first, a few words about stability. Maintaining stability One of the features of much regular discussion of macroeconomic policy, and monetary policy in particular, is that people tend to adopt a rather short time-frame. Everyone watches high-frequency data and adjusts expectations about what policy should or will do accordingly. Policymakers are expected to respond to events and to deviations of economic performance from what had been anticipated. The number of surveys and obscure indicators seen as conveying information has continued to grow, as has the number of commentators to talk about them. To some extent this is perhaps a natural outworking of richer, more complex societies possessing more information and analytical resources, the 24/7 operation of financial markets and a competitive media searching for content. And to a point, it is perfectly reasonable to expect policy to be adjusted in response to relevant information about how things in the economy are tracking relative to policy objectives. The risk, however, is that this process can lead to a mindset in which policymakers end up responding to quite short-term phenomena, using instruments that take quite some time to have their full effect, including effects that might actually turn out to be adverse. This is relevant to our situation. A period of somewhat disappointing, even if hardly disastrous, economic growth outcomes, and inflation that has been well contained, has seen interest rates decline to very low levels. The question of whether they might be reduced further remains, as I have said before, on the table. But in answering that question, it is not quite good enough simply to say that evidence of continuing softness should necessarily result in further cuts in rates, without considering the longer-term risks involved. Monetary policy works partly by prompting risk-taking behaviour. In some ways that is good: in some respects, there has not been enough risk-taking behaviour. But the risk-taking behaviour most responsive to monetary policy is of the BIS central bankers’ speeches financial type. To a point, that is probably a pre-requisite for the “real economy” risk-taking that we most want. But beyond a certain point, it can be dangerous. Deciding when such a point has been reached is, unavoidably, a highly judgemental process. And that is after the event, let alone beforehand. My judgement would be that policy settings that fostered a return to the sort of upward trend in household leverage we saw up to 2006 would have a high likelihood, some time down the track, of being judged to have gone too far. That is not the case at present, given the current rates of credit growth and so on. But the point is simply that in meeting the challenge of securing growth in the near term, the stability of future economic performance can’t be dismissed as a consideration. A balance has to be found. I note that the Board’s post-meeting statements routinely refer to seeking a stance of policy that will “most effectively foster sustainable growth and inflation consistent with the target” (emphasis added). The adjective “sustainable” is used deliberately and financial sustainability is very definitely one of the things we have in mind. Securing prosperity The transition in growth is not perfectly smooth, but our economy has, in my judgement, coped remarkably well through a lengthy period of very large shocks in a difficult world. Despite the doom and gloom and fulminations over the airwaves, in newspapers and in cyberspace, business confidence has risen in recent months. One day last week as I was preparing these remarks, newspapers carried stories that personal insolvencies are the lowest for more than a decade. On the same day we could read that income inequality in Australia, as measured in the most detailed survey available, has not, in fact, increased, contrary to the impression so often given. Perhaps we might be allowed to conclude that we have been meeting some of our challenges, thus far, with outcomes that, while not perfect, are not too bad. So there are reasons to feel more confidence in our future than we often seem to. The question to be asking is how we build on the broadly successful record we have in order to secure prosperity in the future. In this context, it is likely that questions about potential growth, in per head terms, will become even more prominent. This is partly because of the well-known implications of the lower terms of trade for income per head (i.e. it grows more slowly than output per head). It is partly about demographics, also a well-known issue. Ageing will lower the proportion of people working and hence, other things equal, output and income per head in the country. We all know these things at an intellectual level. But unless we think our wants, including for publicly provided services, will grow more slowly, which I doubt, the very practical imperative will increasingly be to secure sources of growth. And it is increasingly clear to people that the kind of sustained growth in mind here won’t be the result of the manipulation of interest rates or year-to-year government fiscal settings. Demand management policies play an important role, but they have their limitations. Raising the economy’s potential isn’t just some esoteric concern for economists, or at least it shouldn’t be. Our collective ability to deliver social policy outcomes, to enjoy the benefits of a “good society”, or at a more basic level to provide public services and even to defend ourselves, ultimately rests on a productive economy. Many problems, including distributional ones, are easier to deal with if per capita incomes are rising steadily, less so if they are stagnant. Let’s be clear that this is not “growth at any price”. Wealthy countries tend to have cleaner air, cleaner water, better health and education systems, and more demanding standards for environmental protection, employee safety and leave entitlements. They can afford to devote resources to such things because their business sector is so productive. They tend also to have higher wages – not because they decree wages shall be high but because welleducated, skilled workforces working with a lot of capital and modern technology are more BIS central bankers’ speeches productive. The poorest peoples usually have far less in the way of such things. If we care about wellbeing in the broadest sense, we should care about things that affect potential output per head. Our citizens certainly care about the results. They don’t frame the question as being about per capita real GDP or productivity per hour and they care about more than just “narrow” outcomes for economic statistics. Many would be concerned to reduce our environmental footprint. They would not wish to sacrifice civilising aspects of our society and culture, including many that result from government intervention. But nor will they accept a future in which they are marginalised in the global village because of unwillingness to adapt or to invest, or because of a failure to foster a growth economy. There is a lot of talk at present about “reform”. I would suggest that the case for “reform” needs to be presented as a positive narrative for economic growth. We all know that competitive markets, investment in education, skills and infrastructure, and adaptability, are key parts of that growth narrative. These reforms matter because of the gains to incomes resulting from better allocative efficiency. But they also, ideally, would support entrepreneurship and innovation – “risktaking” by another name and of the kind we want. Measuring “entrepreneurship” is not straightforward and various studies have somewhat differing results. At the risk of oversimplifying, one might say that Australians hold our own in the entrepreneurship stakes, but since we don’t generally score at the top in such surveys, there must be scope to improve. That too can be part of the growth narrative – the narrative of how we build on the success enjoyed to date and secure an even more prosperous future. Conclusion Thank you again for your attention, and for your support of the Anika Foundation. I hope to see you again in another year for a new round of challenges. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 7 |
Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the 54th Shann Memorial Lecture, Perth, 12 August 2015. | Philip Lowe: National wealth, land values and monetary policy Address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the 54th Shann Memorial Lecture, Perth, 12 August 2015. * * * Accompanying charts can be found at the end of the speech. I would like to thank Gianni La Cava and Christian Gillitzer for assistance in the preparation of this talk. It is a great honour for me to have been invited to deliver the Shann Memorial Lecture for 2015. I would like to thank the University of Western Australia very much for this privilege and I am delighted to be in Perth once again. Edward Shann stands tall in the list of Australia’s distinguished economists. His work emphasised the importance of looking back to history to understand what the future might hold for us. He was a tireless advocate for market-based policies, including in commodity, labour and foreign exchange markets. He was a strong and prominent voice against the tariff wall that had been built around Australian industry. And his writings emphasised the importance of spending public money wisely and the dangers of excessive and poorly designed regulation. I suspect that if Shann was among us this evening, he would see much that he liked in the Australian economy of 2015. While we still have work to do, in many respects we are closer to the world that he advocated than we were in the 1920s when he was doing much of his work. Most of us, I think, would agree that the general move to a fairly liberalised marketbased economy has served Australia and its people well. Reading through Shann’s work in preparation for this evening’s talk, I was struck by his fascination with two other very modern Australian interests: balance sheets and land prices. While I didn’t come across him using the exact term “balance sheets”, Shann’s writings display a deep interest in the evolution of the liabilities and assets of both the public and private sectors. He understood the dangers of excess leverage. He understood the importance of making sure that assets generated a return to cover their financing costs. And he understood the difference between current economic activity and the accumulation of wealth. But it is Shann’s discussion of land prices that really makes his writings come to life. He talks of “bubbles”, of “log-rollers” pushing projects that increased the value of their own land and of the antics of the “land-jobbers”. And, when talking of the land boom of the 1880s, he cites with, I think, some disquiet, TA Goghlan’s observation that “Free conveyances carried people to the sales, champagne lunches gave them courage to bid, and extraordinary terms of credit reconciled them to their purchases.” 1 Today, people mostly find their own way to property sales and I hope that champagne is consumed only after the bidding process has stopped. But, our fascination with land, its value, and its financing has endured. In a way, it has become part of our national culture. It is this interest of Shann’s in balance sheets and land that serves as the motivation for my remarks this evening. Most of the time, economic commentary focuses on changes in income and spending: things such as changes in GDP, consumption, retail trade, exports, etc. Most of the time, much less attention is paid to the developments in our national balance sheet. And when attention does turn to the balance sheet, the focus is often on the liability side, not on the asset side. So, See Shann (1927), (1930, ch XVII, p312). BIS central bankers’ speeches this evening, I would like to take this opportunity to talk a little about Australia’s national balance sheet, and particularly the asset side. My remarks are in three parts. In the first part, I will look at what we know about our balance sheet and how it has changed over time, including the relative importance of land and physical capital. In the second part, I will discuss the increased value of our land and how we might interpret the changes that have taken place. And then, finally, I will discuss how some of these issues have a bearing on monetary policy. Australia’s national balance sheet So, first to our national balance sheet and what we know about Australia’s net wealth. Constructing a national balance sheet is a challenging task, with measurement problems almost everywhere one looks. While the value of physical assets can be estimated with some precision, estimating the value of other assets can be extremely complicated. One of Australia’s most important national assets is our institutional arrangements: things like the rule of law, our strong and credible institutions, and our stable political system. But putting a monetary value on these particular assets is nigh impossible. 2 There are also challenges in measuring the value of other important national assets, including our cultural heritage, our human capital and our rich and varied natural environment. There are various efforts around the world trying to make progress on how to measure these types of assets, but most of this work remains experimental. 3 This means that inevitably, the construction of a national balance sheet is only partial, covering the elements that we can measure with some confidence. Notwithstanding this, since the late 1980s, the Australian Bureau of Statistics (ABS) has been producing an annual balance sheet for Australia, including an annual estimate of Australia’s net wealth, that is, the difference in the value of our assets and our liabilities. There are two “technical” issues that are worth pointing out before talking about this balance sheet in some detail. The first is that while the balance sheet includes a wide range of assets, it does not incorporate the assets that I was just talking about. 4 The assets that are included are manmade physical assets – such as buildings, infrastructure, and plant and equipment – as well as land, weapons systems, livestock and timber, inventories and known mineral resources. A number of intangible assets are also included, such as computer software, some intellectual property, and research and development assets. So it is a broad list of both private and public assets, but not a universal list. The second technical point is that the balance sheet does not include financing transactions that are “internal” to Australia; that is, it does not record when one Australian entity provides finance to another. This reflects the fact that while financial transactions between Australians do affect the risk profile of individual balance sheets within the economy, they do not, by themselves, change our national net wealth. It is what is done with this internal finance that matters for wealth. To some extent the value of these institutional arrangements is capitalised into our land prices. Some years ago the ABS (Wei 2004, 2008) produced experimental estimates of human capital stocks and flows for Australia. Boarini et al (2012) provide a cross-country review of practices to measuring human capital. The United Nations Statistical Commission’s ‘System of Environmental-Economic Accounting’ provides a framework to unify statistical information on the environment and its relationship with the economy. The ABS has been producing a Water Account since the early 2000s, providing information on the physical and monetary supply and use of water in the Australian economy. Australian Bureau of Statistics (2014). BIS central bankers’ speeches In contrast to domestic financing transactions, when we draw on funding from the rest of the world, or buy assets overseas, our net asset position as a country does change. This means that financial transactions with the rest of the world are included in the national balance sheet. So, to the data. There are four broad observations to which I would like to draw your attention. The first is that according to the ABS’ latest estimates, the total value of Australia’s assets as at end June 2014 was around $12½ trillion, or around $500,000 for each person living in Australia. After an adjustment is made for net foreign liabilities, the net asset position, or net wealth, was around $10 trillion, which is the equivalent to around six times Australia’s annual GDP. The second observation is that, over recent decades, net wealth has increased at a faster rate than has GDP (Graph 1). Between 1989 and 2014, the nominal value of net wealth increased at an average pace of around 7 per cent per year, compared with an average increase in nominal GDP of around 6 per cent. While net wealth grew more slowly than GDP in the first half of the 1990s, for most of the time since it has grown more quickly than GDP. The third observation relates to the composition of our national assets (Graph 2). Land is the asset class with the highest value. As at June 2014, it accounted for 34 per cent of the value of our national assets. This is followed by non-dwelling construction – offices, factories, infrastructure, etc. – which accounts for a further 18 per cent of total assets. And then overseas financial assets and the value of our dwellings each account for a little under 15 per cent of the national balance sheet. Intellectual property assets account for only around 2 per cent of the total. The final and perhaps most interesting set of observations relate to how the structure of the balance sheet has changed through time. One very clear trend has been a substantial increase in the value of our foreign financial assets and liabilities; both have increased much faster than net wealth (Graph 3). In effect, as we have become more globally integrated as a nation, there has been a grossing-up of our balance sheet with the rest of the world. Australians now hold many more overseas assets than they once did. And, conversely, overseas residents now hold many more Australian assets than they once did. In net terms, Australia still has a net liability position with the rest of the world, having been a drawer on overseas savings for more than 200 years. Interestingly though, while our net liability position, relative to our national income, has been relatively steady in recent decades, relative to the value of our national assets it has declined and is currently at the lowest level in around 25 years (Graph 4). In terms of the non-financial assets, there have also been significant changes over time (Graph 5). The most striking of these is the increase in the relative importance of land. Indeed, almost three-quarters of the increase in the ratio of net wealth to GDP since the late 1980s is explained by higher land prices. Given the significance of this change, I want to explore why it has occurred and its implications a little later in this talk. But before I do so, it is worth talking about other changes in the national balance sheet. One of these is the noticeable increase in the value of our mineral and energy resources. 5 In 1989, these assets accounted for just 3 per cent of net wealth. Today, the figure is 12 per The value of these resources is estimated as the current value of economically exploitable resources given current technology and prices. Price estimates are based on a 5-year lagged moving average. BIS central bankers’ speeches cent. This rise reflects both the discovery of new resources and higher commodity prices. These higher prices have increased the present discounted value of expected future production, as well as the share of the existing known reserves that can be extracted economically at some point in the future. One aspect of the balance sheet that has shown relatively little net change over time is the value of non-dwelling construction assets, relative to GDP. The relative valuation of these assets did decline over the 1990s, but this trend reversed in the 2000s with the investment boom in the resources sector. In contrast, the value of machinery and equipment, relative to GDP, has fallen steadily since at least the late 1980s, although this is largely explained by the fall in the relative price of machinery and equipment. Looking to the future, it is important that Australia continues to invest in our asset base. While growth in the overall capital stock has been strong in recent years because of developments in the resources sector, growth in the non-mining capital stock has been noticeably weaker. This weak growth is partly cyclical, although it is proving to be more protracted than earlier expected. There may also be a structural element, and it is possible that, over time, we might return to the earlier general downward trend in the value of our physical capital stock relative to GDP. One contributing factor here is that a number of the strongly growing services industries are more intensive in human capital than in physical capital. Given this, our focus needs to be not just on creating an environment that is conducive to the accumulation of physical assets but, perhaps even more importantly over the medium term, on the accumulation of human capital. One other aspect of the current debates about investment that I am sure Shann would have found very interesting is that surrounding infrastructure investment. His writings drew attention to the important role that such investment can play in a growing economy. But they also emphasised the importance of making sure that investments in infrastructure generate an appropriate rate of return. In his short book about the 1890s and the 1920s, Shann writes “Public works are excellent things, but only so long as the balance is preserved between capital and earning power”. In this context, he writes approvingly of the appointment by Sir Henry Parkes in 1888 of Edward Eddy as the Chief Commissioner of Railways in New South Wales, stating that: “Eddy raised the return on the capital invested in the New South Wales railways from 2.85 per cent to 3.58 per cent, and in tramways from 1.98 per cent to 5.28 per cent”. He contrasts this with the outcomes in Victoria where he writes with strong disapproval that the Victorian railways commissioner, Richard Speight, “caught the feverish spirit of speculation”. 6 Shann’s general observations in the area transcend time. If we fast forward to the Australia of 2015, there is a reasonable case that there are a number of investments in new infrastructure assets that would satisfy Shann’s test that “the balance is preserved between capital and earning power”. This is especially so when funding costs today are lower than at the time when Shann was writing, and indeed, in many cases, the lowest since Federation. But, as he often pointed out, money spent on infrastructure can be wasted easily. The key here is to ensure that the right projects are selected, the construction costs are well controlled and that the risk-sharing between the public and private sectors serves the public interest. Getting these “governance issues” right is far from straightforward, but it is not impossible. Making progress on this front would help us build the infrastructure assets that would strengthen our national balance sheet and lift our productive capacity. The quotes here come from Shann (1927), pp 30, 33 and 12, respectively. BIS central bankers’ speeches The final aspect of this balance sheet to which I want to draw your attention before returning to the issue of land prices is the gradual, albeit relatively small, increase in the value of our dwellings (excluding the land component) relative to our incomes. There are a number of factors that have contributed to this increase. One is that, since the late 1980s the average number of people living in each dwelling has fallen a little, so that the number of dwellings has increased a bit more quickly than the population. Another is that, over time, the average quality of our dwellings has improved and the average size of the dwellings has increased; for example, since the late 1980s, the average floorspace of newly constructed houses has risen by around 45 per cent (Graph 6). Interestingly, both of these trends – that is, towards smaller households but bigger dwellings – seem to have reversed in recent times. These data put into some perspective the claims that are sometimes made that Australians are investing too much in housing. In a sense, the upward drift in the value of the constructed housing stock, relative to our incomes, looks neither surprising, nor remarkable. Right around the world, as people’s incomes rise, they tend to use the extra income to purchase better dwellings. Instead, what is perhaps more remarkable is the extra resources that Australian households have used to purchase, from one another, the land on which these bigger and better dwellings sit. Indeed, most of the extra money that has gone into residential property has not gone not into the physical stock of housing, but rather into land. So our fascination with housing is really, mostly, a fascination with land. Land values and wealth I would now like to explore this rise in the value of our land, and its implications, in a bit more detail. Taken literally, the figures that I have presented invite the conclusion that our national wealth has risen largely because of higher land prices. But is such a conclusion really warranted? Have we really become wealthier as a nation simply because the value of our land has increased? The answer would clearly be yes if this increase was because we had discovered more land. To my knowledge, though, this has not happened. 7 It would also be yes if the main factor driving the increase in land prices was a large leap in productivity of our agricultural land. Over time, crop yields have indeed increased substantially, but the resulting higher value of rural land accounts for only 5 per cent of the increase in the total value of land in Australia since the late 1980s. 8 Instead, almost all the increase has come from the higher value of the land upon which our dwellings are built in the towns and cities across Australia (Graph 7). So, how do we explain this increase in the value of our residential land over recent decades? There are two main structural factors. While the physical land area of Australia has not changed, the ABS volume estimates for land have increased over time, reflecting improvements in land quality. The ABS assumes that the volume of urban land increases at half the rate of growth in the volume of overlying non-dwelling construction and one-third the rate of growth in the volume of overlying dwelling construction. There is no change in rural land volume over time, with rezoning of rural land to urban use assumed to be offset by rural land improvements. Currently, rural land accounts for just 6 per cent of the value of land in Australia. In contrast, Scott estimates that in 1930 rural land accounted for 57 per cent of the total value of private land on an unimproved basis and 43 per cent on an improved basis. BIS central bankers’ speeches The first is the combination of financial liberalisation and low inflation. In the 1970s and 1980s, regulation of the financial system and high inflation served to hold down land prices artificially. They did this by limiting the amount that people could borrow. When the financial system was liberalised and low inflation became the norm, people’s borrowing capacity increased. Many Australians took advantage of this and borrowed more in an effort to buy a better property than they previously could have done. But, of course, collectively we can’t all move to better properties. And so the main effect of increased borrowing capacity was to push up housing prices, and that means land prices. The second factor is the combination of strong population growth and the structural difficulties of increasing the effective supply of residential land. Since 1989, the Australian population has increased by more than 40 per cent, or around 7 million people, one of the fastest rates of increase among the advanced economies. The difficulties of responding to this on the supply side of the housing market have been well documented. 9 They include the challenges of developing land on the urban fringe and of rezoning land close to city centres for urban infill. They also include, in some areas, underinvestment in transportation infrastructure. This underinvestment has effectively constrained the growth in the supply of “well-located” land at a time when demand for this type of land has grown very strongly. The result has been a higher average price of land in our major cities. Another possible structural explanation is that the higher land prices reflect an upward revision to people’s expectations of future income growth and thus the amount they are prepared to pay for housing services. One possible reason for this is that the growth of our cities generates a positive externality – by bringing more people together competition is improved and productivity is higher. While this might be part of the story, I think it is unlikely to be a central part. Real income growth per capita did pick up markedly from around the mid 1990s, but it has subsequently slowed substantially, with apparently little effect on the price of land relative to income. So the story is really one of increased borrowing capacity, strong population growth and a slow supply response. One might ask why it matters why land prices have risen. After all, regardless of the reason, higher land prices have delivered large capital gains to many Australians and have made them better off. The complication here comes from the fact that Australians are both owners of housing assets and consumers of housing services. We don’t just own housing and the land on which it is built, but we also live in that housing, and on that land. And that housing and land provide us with valuable services. If housing is fairly valued – in the sense that the price of housing is equal to the present discounted value of the future rents – then the rise in prices implies an increase in the expected future cost of housing services. So, from the perspective of society as a whole, much of what is gained on the one hand is lost on the other: there are windfall gains from higher land prices but then everyone pays more for housing services. 10 How any one individual is affected by all of this depends upon their own circumstances. Productivity Commission (2011) discusses the role of planning, zoning and development assessments. Kulish et al (2012) use a calibrated model to study the effect of supply constraints on density and the price of land in an Australian context, while Gitelman and Otto (2012) provide supply elasticity estimates for residential property in Sydney. For a theoretical treatment of this point, see Buiter (2008). BIS central bankers’ speeches For an older person who owns their own home and has no children, the capital gain from the higher land prices more than offsets the expected higher future housing costs. Such a household is better off. The same is true for owners of investment properties, since they own multiple dwellings on which they earn a capital gain. In contrast, for young homeowners with multiple children, the calculation can look quite different. If they care about the future housing costs of their children, then, in some circumstances, it is possible that the higher future expected housing costs could exceed the capital gain on their dwelling. In a welfare sense, the increase in land prices could make them worse off, even though they own land. The same is obviously true for renters as they do not have any capital gain to offset the higher future housing costs. One might think that only an economist would argue in these terms: to worry that a capital gain on an asset that you own could actually make you worse off because of some vague notion of higher future housing costs, especially for your children. And you might be right. But I think many Australians have an innate understanding of the concept and share the concern. Many parents around the country look at the high housing (really land) prices and worry that their children will not be able to afford the type of property that they themselves have been able to live in, even if their children were to have the same life-time income profile as they have had. In effect, these parents are doing the present discounted value calculation and they see the potential problem. So it is arguable that the main impact of higher land prices is not really to increase our national wealth, but to change the distribution of that wealth. The distributional effects are in two dimensions. The first is cross-sectional, with the existing owners of dwellings receiving capital gains when land prices increase. The second is the distribution of wealth across generations, with the current owners of dwellings earning capital gains but future generations paying higher housing costs. Both of these aspects of changing wealth distribution have economic and social consequences, neither of which, I suspect, are yet fully understood. How the intergenerational distribution ultimately plays out will depend critically upon the extent to which the gains that have accrued to the current generation are passed on to the next generation. In general, we know relatively little about intergenerational transfers, but what we do know suggests that things may be changing gradually. One illustration of this can be seen in the Household, Income and Labour Dynamics in Australia (HILDA) Survey, which suggests that, over time, there has been some increase in the share of first-home buyers that are receiving loans from family and friends (Graph 8). There is also some evidence of younger generations receiving increased assistance with household expenses from older generations, including by continuing to live in the family home. It is quite likely that these trends will continue with it becoming more commonplace for parents to help their children in the property market. This has both economic and social consequences. Of course, if this type of intergenerational assistance does become more common, then fewer parents will be able to use the capital gains that they have benefited from to boost their own consumption. Instead, in effect, they will be using those capital gains to support the following generations with their higher housing costs. Alternatively, if it turns out that today’s generations use their capital gains to increase their own spending, then they will have less ability to help their children. If this were to happen, I suspect that, over time there would be some downward pressure on the price of housing, relative to incomes, as future generations deal with the high cost of housing. Implications for monetary policy In the remaining time I would like to touch on three issues relevant to monetary policy that are closely related to the issues I have been talking about. BIS central bankers’ speeches Higher land prices and spending The first of these is the link between higher housing prices and household spending. There is a well-established research literature empirically demonstrating that higher housing wealth boosts household consumption. For example, work done by my colleagues at the Reserve Bank of Australia (RBA) has estimated that a rise in wealth of $100 leads to a rise in non-housing spending of between $2 and $4 per year. 11 There are two commonly accepted channels that explain this relationship. The first is a pure wealth channel. To the extent that higher dwelling prices are perceived to increase wealth, households should spend a little of that extra wealth each year over their lifetime. The second is the collateral channel, as higher land prices increase the value of collateral that can be posted by potential borrowers. The increased collateral makes it easier for creditconstrained households to borrow to increase their spending. Similarly, businesses can find it easier to finance projects that previously might have struggled to get finance. 12 Over recent years, there has, however, been some reinterpretation of the role of the pure wealth channel. In part, this reflects the issues that I was speaking about a few moments ago; that is, that higher housing prices not only deliver capital gains to the existing owners but also imply a higher price of future housing services. The reinterpretation of the evidence is that the link between housing wealth and spending arises not so much through the traditional pure wealth channel, but rather because higher housing prices are sometimes a proxy for faster expected income growth into the future. And it is this lift in expected income growth that spending is really responding to. Interestingly, other colleagues at the RBA have recently been examining this idea, again using household level data from the HILDA Survey. 13 They find clear evidence in favour of a collateral channel, especially for younger households who are more likely to be credit constrained. In contrast, they find no evidence in favour of the traditional pure wealth effect. Instead, their evidence is consistent with the alternative expected-income idea. Perhaps, the most intriguing aspect of their results is that when housing prices in a particular area increase, renters in that area increase their consumption. The increase is not as large as for owner occupiers, but it is an increase. The conclusion that my colleagues reach is that it is a common third factor such as higher expected future income, or less income uncertainty, that is, at least partly, responsible for the observed association between housing wealth and spending. If this conclusion is correct, then I think it helps partly explain what is going on in the economy at the moment. In the early 2000s, when housing prices and real incomes were rising quickly, many households used the higher value of their housing assets to increase their spending. Nowadays, this is not happening on the same scale that it once was. With slower expected future income growth and increased concerns about future housing costs, the response to higher housing prices looks to be smaller than it was previously. And this smaller response is affecting overall spending in the economy. See, for example, Dvornak and Kohler (2007). Recent work at the RBA also suggest that higher housing wealth provides collateral for small-business borrowing and is associated with higher levels of business formation (see Connolly, La Cava and Read 2015). See Windsor, Jääskelä and Finlay (2015). BIS central bankers’ speeches Liabilities and risk The second issue that I wanted to touch on is the increase in debt that has accompanied the increase in land prices. Throughout this talk I have barely touched on the liability side of the balance sheet. This is largely for the reason that I spoke about at the start, namely that financing transactions that are internal to the country do not change Australia’s net wealth. However, these transactions can have a material impact on the profile and riskiness of the individual balance sheets within the economy. The rise in land prices that I have spoken about is inextricably linked to the rise in household borrowing. Together, these two developments have grossed up the household sector’s balance sheet (Graph 9). This means that, on the assets side of the balance sheet, a given percentage change in housing prices has a bigger effect than it once did. And on the liabilities side, movements in interest rates also have a bigger effect. We are still trying to understand fully the implications of all of this. However, I think it is difficult to escape the conclusion that household balance sheets are, on average, a little more risky than they once were. Many Australian households also seem to have reached a similar conclusion. This is reflected in the decision by many Australians to take a more prudent approach to their spending over recent years. I suspect that it is unlikely to be in our national interest for this more prudent approach to give way to household consumption once again growing consistently much faster than our incomes. This is something we continue to be cognisant of in the setting of monetary policy. Some decline in the rate of household saving is probably appropriate as the economy rebalances after the terms of trade and mining investment booms. But, given the position of household balance sheets, it is unlikely to be in our long-term interest for a consumption boom to be financed by a pick-up in household borrowing. Generating growth That brings me to my final issue: that is the need to generate sustainable growth in the economy. Monetary policy can play some role here, including by helping reduce uncertainty by maintaining low and stable inflation and overall stability in the economy. But monetary policy is, ultimately, not a driver of medium-term economic growth. Indeed, while low interest rates are currently helping the economy through a period of transition, an extended period of low interest rates implies ongoing low returns to savers and low underlying returns on assets. This is not a world to which we should aspire. One of the challenges we face as a country is to lift the expected risk-adjusted return on investment in new assets, whether they be physical assets or human capital. If we can do this, then we will see the investment in new assets that is crucial to the sustainable expansion in the economy. There is no single lever that can be pulled here. But neither is there a shortage of sensible ideas that, if implemented, could improve the environment for the creation of new assets in Australia. These ideas include: a strengthening of the culture of innovation; the removal of unnecessary and overly complicated regulation; and making competition work effectively in markets across the country. Increased investment in infrastructure, including in transport, probably also has a role to play here. Done properly, it could help lift the return to other forms of investment in a wide range of industries across the economy. Better transportation can also increase the effective supply of well-located land, making housing more affordable for many Australians. None of this is easy, but neither is it impossible. BIS central bankers’ speeches Concluding Remarks Let me conclude by trying to bring these remarks together with three brief closing observations. The first is that rising land and housing prices have made many, but not all, Australians better off. They have also changed the distribution of wealth within our society and between generations. And we are still coming to grips with the implications of this. Ever-rising housing prices, relative to our incomes, do increase risks in the economy and are unlikely to make us better off as a nation. Rising housing prices are best matched by rising incomes. The second observation is that real wealth generation for the society as a whole comes from asset accumulation and lifting our productivity. While the rise in the value of our resource base over the past decade has improved our national balance sheet substantially, we cannot rely on this occurring again. Further improvement in our national balance sheet requires us to invest in both physical and human capital. And it requires us to come with new ideas and better ways of doing things. And the third, and related observation, is that balance sheets have two sides. They have a liabilities side and they have an assets side. Both sides need to be managed carefully. We need to make sure that our liabilities are sustainable and that they are managed prudently. Shann’s writings remind us of what can happen if we do not do this. But we also need to make sure that we continue to invest in the assets that form the base of sustainable growth in national income over the years ahead. Thank you very much for listening this evening. I would be very happy to answer any questions. References Australian Bureau of Statistics (2015), Australian System of National Accounts: Concepts, Sources and Methods, 2014, ABS Cat No 5216.0, Chapter 17. Boarini R, M Mira d’Ercole and G Liu (2012), “Approaches to Measuring the Stock of Human Capital: A Review of Country Practices”, OECD Statistics Working Papers, 2012/04, OECD Publishing. Also available <http://dx.doi.org/10.1787/5k8zlm5bc3ns-en>. Buiter Willem H (2008), “Housing Wealth Isn’t Wealth”, NBER Working Paper No 14204. Also available <http://www.nber.org/papers/w14204>. Connolly E, G La Cava and M Read (2015), “Small Business & Finance” in J Simon and A Moore (eds), Housing Prices and Entrepreneurship: Evidence for the Housing Collateral Channel in Australia, Proceedings of a Conference, Reserve Bank of Australia, Sydney. Dvornak N and M Kohler (2007), “Housing Wealth, Stock Market Wealth and Consumption: A Panel Analysis for Australia”, Economic Record, 83(261), pp 117–130. Gitelman E and G Otto (2012), “Supply Elasticity Estimates for the Sydney Housing Market”, Australian Economic Review, 45(2) pp 176–190. Kulish M, A Richards and C Gillitzer (2012), “Urban Structure and Housing Prices: Some Evidence from Australian Cities”, Economic Record, 88(282) pp 303–322. Productivity Commission (2011), Performance Benchmarking of Australian Business Regulation: Planning, Zoning and Development Assessments, Volume 1, Research Report, Canberra. Scott RH (1969), “The Value of Land in Australia”, Paper delivered to the 1969 meeting of the Australian and New Zealand Association for the Advancement of Science (ANZAAS) Congress, Adelaide. Shann EOG (1927), The Boom of 1890 – And Now, Cornstalk Publishing Company, Sydney. BIS central bankers’ speeches Shann EOG (1930), An Economic History of Australia, in particular Chapter XVII, “The Land Boom”, pp 298–315, Cambridge University Press, Cambridge. Wei, H (2004), “Measuring the Stock of Human Capital for Australia”, Methodology Research Papers, ABS Cat No 1351.0.55.001. Wei, H (2008), “Measuring Human Capital Flows for Australia”, Working Paper, cat. no. 1351.0.55.023, Australian Bureau of Statistics, Canberra. Windsor C, J Jääskelä and R Finlay (2015), “Housing Wealth Effects: Evidence from an Australian Panel”, Economica, 82(327), pp 552–577. BIS central bankers’ speeches Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches Graph 5 Graph 6 BIS central bankers’ speeches Graph 7 Graph 8 BIS central bankers’ speeches Graph 9 BIS central bankers’ speeches | reserve bank of australia | 2,015 | 8 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Economic Society of Australia (Qld) Luncheon, Brisbane, 14 August 2015. | Christopher Kent: Adjustments in the labour market Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Economic Society of Australia (Qld) Luncheon, Brisbane, 14 August 2015. * * * I thank Kathryn Davis, David Jacobs, Alexandra Rush, Martin McCarthy, Andrew van der Saag and Madeleine McCowage for excellent assistance in preparing these remarks. Introduction Let me start by thanking the Queensland branch of the Economic Society of Australia for hosting this event today, and special thanks to Michael Knox and Tim Wonhof for their assistance. The Australian economy has been growing at a moderate pace since commodity prices peaked around four years ago. While mining investment has declined substantially since then and has further to fall, resource exports have grown strongly and are expected to do so for some time. Fiscal consolidation at state and federal levels has weighed somewhat on growth. And the exchange rate has been relatively high compared to what one might have expected given these circumstances. At the same time, very low interest rates have been supporting demand. So there have been a range of different forces affecting the economy. Overall, spare capacity in product and labour markets has gradually increased. The unemployment rate rose from around 5 per cent in 2011 to about 6¼ per cent towards the end of last year (Graph 1). Also, the participation rate and the ratio of employment to the working age population had fallen to relatively low levels. But in the face of significant structural change in the economy, the labour market has been adjusting more smoothly over the past year than we had been expecting. Graph 1 When we put our forecasts together earlier this year, we expected moderate growth of economic activity for some time. The GDP growth that has been recorded suggests that we BIS central bankers’ speeches have been about right on this so far. We also thought this would lead to a further gradual increase in the unemployment rate and be accompanied by subdued growth of employment. But, since then, the labour force data have been a bit better than expected. While the unemployment rate remains high, looking through the month-to-month volatility, it has been little changed since the latter part of last year. In addition, employment growth has picked up and has been running ahead of the growth in the working-age population. How can we reconcile better-than-expected labour market outcomes with only moderate growth in GDP? The focus of my remarks today is on four possible explanations for this: • First, recently released data revealed that population growth, and hence the growth of the labour force, has been a bit lower than we’d assumed. In the face of fewer employment opportunities over recent years, particularly in resource-related industries, there has been a decline in the (net) number of immigrants arriving to seek work. While we’d expect the labour supply to respond to economic conditions in Australia relative to those overseas, the adjustment has been more pronounced than earlier anticipated. • Second, wage growth declined as spare capacity in the labour market increased. This is also unsurprising, but the adjustment has been larger than suggested by historical experience. This has probably encouraged more employment growth than otherwise and improved the cost competitiveness of Australian labour. It also acts as a signal to encourage adjustment in the supply of labour. • Third, the composition of growth may be playing a role in boosting demand for labour. While aggregate economic activity has grown at a below average pace, conditions in labour-intensive parts of the economy seem to have improved. • Finally, the key sources of data – the labour force survey and the national accounts – are both subject to measurement error and are often revised. It is possible that the current data are providing a noisy signal of what is actually happening. I’ll go over each of these points in turn and then come back to a discussion of the likely implications of these developments for the economic outlook. Recent developments Changes in population growth As recently as May, official data suggested that the working-age population had been growing by about 1.7 per cent per annum, and it was expected to continue at about that rate in the foreseeable future. However, the most recent data from the ABS suggest that total population growth had dropped quite noticeably over the past year or so, from 1.8 per cent over 2012 to 1.4 per cent over 2014 (Graph 2). Estimates of the working-age population are expected to be revised down accordingly in coming months. BIS central bankers’ speeches Graph 2 The decline in population growth was mainly the result of a decline in net immigration. This appears to be related to the weakening in Australia’s labour market conditions relative to those of other countries. 1 Of course, people on temporary skilled-work visas (so-called “457s”) leave for home when their jobs end. But there has also been a large decline in net immigration from New Zealand. Labour market conditions in New Zealand tightened at the same time that spare capacity in the Australian labour market increased. The reconstruction activity in Christchurch took off around the time that construction in Australia’s resource sector was winding down. Indeed, the key mining states of Queensland and Western Australia have seen the largest declines in net immigration. It also appears that Australia’s intake of international students has not picked up to the extent previously anticipated. 2 The unexpected slowdown in population growth implies somewhat less rapid growth of our labour force than otherwise. This means that the GDP growth that we have recorded may have been closer to the recent growth in the economy’s productive capacity than previously thought. If so, that would have left the economy with a little less spare capacity (a lower unemployment rate) than had been expected. Yet this can only account for part of the unexpected adjustment in the labour market. Most notably, labour demand has also picked up. That is evident in the rise in employment relative to the population. Net immigration had been very high for a number of years and was an important means of addressing skill shortages. Immigration was especially significant in Queensland and Western Australia, where demand for labour from the resource investment boom was most concentrated. As the mining investment boom has wound down, and demand for labour has weakened, these states have also seen the largest declines in net immigration. For more detail see RBA (2015), “Box D: Implications of Lower Population Growth for the Australian Economy”, Statement on Monetary Policy, August, pp 44–46. This discussion is based on data from Statistics New Zealand and the Department of Education and Training. More detail on net immigration by visa category will be released by the Department of Immigration and Border Protection in due course. BIS central bankers’ speeches The role of wage growth One possible explanation for the pick-up in labour demand relates to the large decline in wage growth over recent years (Graph 3). 3 The behaviour of wages during the current episode has been comparable to the experience around the 1990s recession. This is true of nominal wage growth and growth in the cost of the labour required to produce a unit of output – so-called unit labour costs. The decline in real wage growth has also been of a similar magnitude to the early 1990s. Graph 3 While we would normally expect wage growth to decline after a period of subdued labour demand, the decline over recent years has been larger than suggested by historical experience. In particular, although the unemployment rate has increased by much less than during the early 1990s recession, the decline in wage growth during the two episodes has been similar (Graph 4). Graph 4 This section of my talk draws extensively from Jacobs D and A Rush (2015), “Why is Wage Growth so Low?”, RBA Bulletin, June, pp 9–18. BIS central bankers’ speeches There are a number of reasons why wage growth may have been so responsive this time around. 4 For example: • During the boom in commodity prices and mining investment, wage growth increased noticeably and the exchange rate appreciated significantly. This left our wage costs in foreign currency terms quite high once commodity prices had peaked. The subsequent fall in commodity prices was associated with relatively low growth of wages over recent years which, alongside some depreciation of the exchange rate, is helping to restore earlier levels of competitiveness. 5 • Wages may have become more flexible over time. It may be that there has been some general shift in the bargaining power of labour. Also, those industries most exposed to the declines in commodity prices and mining investment have a high share of individual employment contracts. Furthermore, the relatively long span of the current episode means that most employment contracts have been renegotiated during the period of subpar economic growth over recent years. Whatever the reason for the very low growth in labour costs, wage flexibility has assisted with the labour market adjustment. Changes in relative wages act as an incentive for labour to move. Strong increases in wages in the resource sector (in both domestic and foreign currency terms) helped to attract the labour needed to undertake the substantial increase in mining investment (including from overseas). All of these things are now adjusting in the other direction. The weaker wage growth and decline in job opportunities relative to many other countries has probably contributed to the lower growth in the population and labour supply. In addition, low wage growth across the economy has enabled firms to employ more labour than would otherwise have been the case. Even so, my sense is that low wage growth only goes some way to explaining the recent pick-up in labour demand. Compositional change While aggregate GDP growth has been moderate, the composition of economic activity may have underpinned a rise in the demand for labour of late. Growth in consumption, dwelling investment and net service exports have increased over the past year even though GDP growth has eased back a touch in year-ended terms (Graph 5). See Jacobs and Rush (2015) for a more comprehensive discussion of these points. This sort of adjustment was to be expected. For a conceptual framework see Plumb M, C Kent and J Bishop (2013), “Implications for the Australian Economy from Strong Growth in Asia”, RBA Research Discussion Paper No 2013–03. BIS central bankers’ speeches Graph 5 Surveys of businesses suggest that for firms providing services to households, conditions increased substantially from mid 2013 and have been well above average over the past couple of years (Graph 6). Surveyed conditions are also above average for those firms providing business services. Meanwhile, conditions for firms producing or distributing goods remain a bit below average. The surveys of business conditions by sector line up reasonably well with employment growth across sectors. Graph 6 As an interesting aside, variation in business conditions and employment across sectors is consistent with the weakness in business investment. The service sectors, on average, have relatively low capital-to-labour ratios compared to those producing or distributing goods (Graph 7). So in order to satisfy increased demand for services, firms in those sectors have hired more workers but they didn’t need to invest much in machinery & equipment or buildings & structures (compared with firms producing goods). BIS central bankers’ speeches Graph 7 This compositional change in demand towards more labour-intensive industries is part of a longer-running trend. But there is also a cyclical element to it as mining investment unwinds and growth of dwelling investment and consumption (which is increasingly dominated by services) has picked up. 6 Also, the decline in the exchange rate has encouraged Australians and foreigners to direct more of their spending to Australian tourism, education and business services. Measurement error It’s possible that the decline in population growth, very low wage growth and compositional change can explain the adjustments evident in the labour market data even though growth of aggregate economic activity has remained moderate. It is also possible, however, that the picture before us of recent labour market outcomes and economic conditions more generally are being clouded by usual measurement difficulties. There is naturally a degree of statistical noise in the labour force survey, as with any survey data, so it might be providing a noisy read of true labour market conditions. 7 While it is possible that the labour force survey is overstating the true state of demand for workers, it is worth noting that the separate ABS survey of businesses’ vacancies is broadly consistent with the improvement in labour market demand of late. Vacancies have picked up for the nation as a whole since 2013, and most of the growth has been driven by New South Wales and Victoria, and rising vacancies in the service sector (Graph 8). Meanwhile, vacancies in Queensland and Western Australia, and for the goods sector, have been weak. See Kent C (2014), “Ageing and Australia’s Economic Outlook”, Address to the Leading Age Services Australia (LASA) National Congress, Adelaide, 20 October. The labour force series do not yet reflect recently released data showing lower rates of population growth, which implies that the number of people in each labour force category and their growth rates are overstated. However, measures expressed relative to the size of the labour force or population (such as the unemployment rate or employment-to-population ratio) are likely to be largely unaffected by revisions that will flow from the new population data. BIS central bankers’ speeches Graph 8 Similarly, the national accounts data might be understating the growth of economic activity over the past year or so. Some research by my colleagues shows how sizeable these revisions can be. 8 For example, since 1998, the first estimate of year-ended GDP growth has been revised, on average, by ½ percentage point over subsequent years. While we can’t be sure of the recent past, more difficult still is to know what the future holds. The economic outlook We have recently published an account of our latest economic forecasts in the August Statement on Monetary Policy. 9 I won’t repeat the details of those forecasts, but I want to highlight the implications of the four issues I’ve just discussed. Changes in population growth The implications of lower population growth for the outlook for spare capacity depends on its effect on aggregate demand and aggregate supply. Lower population growth implies slightly less growth in aggregate demand for goods and services. At the margin, there will not be as many new residents spending on items for consumption or needing housing. Nor will there be as many new workers that we’d need to equip with capital to do their jobs. Despite the downward revisions to a number of elements of aggregate demand, the unemployment rate is forecast to be a little lower than previously anticipated. In part, this owes to the slightly better starting point for the unemployment rate than earlier assumed. Also the unemployment rate is forecast to remain little changed from levels of recent months over the course of the rest of this year and next. This is because the change in the growth of Bishop J, T Gill and D Lancaster (2013), “GDP Revisions: Measurement and Implications”, RBA Bulletin, June, pp 11–22. RBA (2015), ‘Economic Outlook’, Statement on Monetary Policy, August, pp 65–71. BIS central bankers’ speeches aggregate demand is expected to be broadly matched by lower growth of the economy’s productive capacity, which in turn follows from less growth in the labour force. While that is what we expect, there is considerable uncertainty about both the rate of population growth and its effects on spare capacity. An example might be helpful here. Lower immigration may reflect a fall in the number of people coming to Australia who have a relatively high propensity to participate in the labour force, such as New Zealanders of prime working age. In that case, the implications for the economy’s productive capacity will be larger than if lower immigration was mostly due to fewer international students. It is not clear whether these two groups would have the same effect on demand: both need to feed, clothe and house themselves, but both have different incomes and different propensities to spend and save. Another source of uncertainty affecting the outlook for supply is productivity growth. That is especially hard to forecast at any time. What signal can we take from recent developments? Not much, is my sense. We know that the lower-than-expected population growth will (by itself) lead to a downward revision to employment growth. For the given growth in GDP that has been recorded of late, this implies that existing estimates of recent productivity growth are somewhat understated. In other words, they are likely to be revised a bit higher when the ABS revise employment growth. However, recent measures of productivity growth tend to provide a very noisy signal of future productivity growth. So we haven’t changed our view on the outlook for productivity growth. We assume that it will be around its historical average. The role of wage growth What about relevance of the low growth of wages for the economic outlook? It is reasonable to be concerned that low wage growth might weigh on labour income thereby weakening the outlook for aggregate demand. But that is an incomplete description of a more complicated process. In particular, wages tend to lag the business cycle, not lead it. This makes sense for at least two reasons. First, many wages are determined by fixed-term agreements. So they take time to adjust to changing conditions in the labour market. Second, even after growth of output picks up, it can take time to absorb spare capacity in the labour market, and hence for wage pressures to build. Given this, the low wage growth of recent years is perhaps best viewed as a response to the spare capacity that has built up in the labour market over time. If wage growth had not been so responsive, it is likely that employment would have been less and the unemployment rate higher than we’ve seen. So even though low wage growth works to constrain the growth of incomes for those who are employed, it also supports incomes by encouraging more employment than otherwise. Compositional change The outlook for the labour market will also depend on the composition of future labour demand. When looking for signs of a turnaround in economic activity, attention is often focused on the tangible things that tend to be measured more easily – the goods we produce and consume, and the machinery, buildings and infrastructure in which we invest. Yet a large and increasing share of our economic activity consists of the services we provide, use and enjoy as well as the investment in intangible capital, including human capital. About half of us are now employed in the service industries. This has increased from about 45 per cent two decades ago. But over the past three years, the additional workers employed in service industries have outnumbered the extra workers employed in the goods sector by a factor of five to one (347 thousand compared to only 73 thousand). 10 Those employed in While the raw numbers of employees have not yet been revised in light of new population estimates (see footnote 7), the relative status of each sector is not likely to change significantly. BIS central bankers’ speeches services require relatively less capital to work with than workers employed in the goods sector. And as I mentioned, while some of the recent improvement in the services sector is likely to be part of a longer-running trend, part of it may also be cyclical. Signals from the various business surveys, the ABS labour force and vacancies data, can provide a timely guide as to the health of the increasingly important services sector. Measurement error This leads me back to the issue of measurement. Output and productivity in the services sector is more difficult to measure than it is for the goods sector. But with services becoming an increasingly large share of the economy, finding better ways to measure the contribution of services to the economy in real terms is going to become increasingly important in understanding our performance. The key issue is that improvements in the quality of services are hard to measure, but these are an important source of improvements in our economic wellbeing. Conclusions In summary, the economy has been adjusting to the various headwinds it has faced in recent years. Even though measured GDP growth has remained moderate over the past year or so, the unemployment rate appears to have stabilised and demand for labour has picked up. Flexibility in labour markets has played a role in these adjustments. One aspect of that has been some change in the growth of the labour supply via changes in the extent of immigration. Another aspect of the adjustment has been the very low growth of wages, which has helped to support a pick-up in employment growth. The improvement in labour demand is consistent with the rise in consumption growth, strong dwelling investment and an increasing contribution to GDP from net services exports. It is also apparent in improvements in survey measures of business conditions, vacancies and employment in the service sectors. While there is uncertainty around our forecasts, including because of the usual noise in data, these developments suggest that there will be slightly less spare capacity in the labour market than earlier anticipated. In particular, we expect the unemployment rate to be little changed from recent levels over the next 18 months or so, before declining in 2017. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 8 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the National Reform Summit, hosted by The Australian and The Australian Financial Review, Sydney, 26 August 2015. | Glenn Stevens: “Reform” and economic growth Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the National Reform Summit, hosted by The Australian and The Australian Financial Review, Sydney, 26 August 2015. * * * Thank you for the invitation to take part in this very important discussion. It is pleasing to see so many influential people coming together for a discussion about the country’s economic future. In a sense, I am really an observer here, because the things you need to grapple with today are mostly outside my remit. Australia’s monetary system is still – I trust – well supported by all the key stakeholders here. It has helped to deliver good outcomes. Our financial sector is robust and stable. But a stable monetary standard and a strong financial system, while necessary conditions for prosperity, are not sufficient ones. More is needed – and that’s why you are here. Your topic is “reform” in the broad. It’s a term that will be used frequently over the next few hours. What does it mean? Often it is presented through the lens of allocative efficiency, otherwise known as productivity. And this is very important. Ideally, production and demand each face and respond to, without distortion or impediment, underlying relative costs. Those relative costs are given by the state of human and physical capital, technology, natural resource endowments and so on. Generally, economists think optimal allocative efficiency is achieved by removing barriers to competition in markets – be they tariffs, subsidies, protectionist devices, unnecessary regulation – and allowing relative prices to allocate productive resources. For most products, competitive markets will deliver the greatest choice at the lowest price to informed consumers. Granted, there are various exceptions to the generalisation above. Where markets are “natural monopolies” or externalities exist, for example, regulation is called for. Good outcomes won’t occur if consumers are not well informed. And so on. Nonetheless, I would venture that the biggest gains to prosperity over the past 25 years have come from more competition. (Aside, that is, from gains from the terms of trade, about which we can do nothing and which usually don’t keep coming). Competition lowers prices and costs. It promotes the drive to do better, which spurs innovation. Minimising distortions due to the tax system also has a role in enhancing allocative efficiency. These things remain important. You should talk about them today. The “to do list” remains substantial. In arguing the case for reform, though, the way the discussion is framed matters. I would like to suggest that “reform” is a term which excites the intellectual elites and the various interest groups (including those who feel they have something to lose from reform) but doesn’t do much to excite the general public. And getting buy-in from them is ultimately critical. To be sure, they have to be led. But they have to be convinced too. I submit that the general public is much more likely to grasp, intuitively, a conversation about growth. Growth in jobs, in incomes, in their standard of living, wealth and prosperity. Better BIS central bankers’ speeches allocative efficiency, if we could secure it, would doubtless add to growth. That growth is worth having. But the story is also about how to secure more dynamic effects: increasing the resources available to be deployed in economic activities of various kinds; fostering conditions under which innovation and genuine risk-taking flourish. In that regard, how to minimise adverse effects on work effort, enterprise, capital accumulation and innovation, due to tax or other factors, would be a worthwhile question – accepting, as a condition, that there is an amount of revenue the government must raise to fund the provision of services only the government can supply. Minimising those adverse effects means a larger economy; more income; more revenue and so on. In parallel, there is no avoiding the need to have the right labour market arrangements. The question is how to have suitable rules that offer basic fairness, but with minimum adverse effects on enterprise, employment, and the scope for free agents to come together in ways that mutually suit them – and that grow the economy. Whether we have that balance right is a question you might address. Growth is important. And for a while now, there has not been quite enough growth. There has been growth, and more than in many countries. But, recent labour market outcomes notwithstanding, not as much as we ought to be capable of. Growth rates have mostly started with a “2” for a while now – despite the lowest interest rates in our lifetimes, banks able and willing to lend and measures of consumer and business confidence generally about average (notwithstanding what we keep reading in the media). This may be simply a feature of the post-financial crisis world – the need for balance sheet repair. It may be about changing demographics. It may be that potential growth is a bit lower than we used to think – though I don’t think we can know whether that is so at present. But whatever the factors at work, we are unavoidably and inexorably being led to the question: how do we get more growth? The fiscal policy debate, usually framed as “when will we get back to surplus?” is actually about: how do we get more growth? Other discussions, so often framed as about “fairness” – that is income distribution – might be better framed as: how do we grow the pie? That isn’t because distribution doesn’t matter. It’s because distributional issues surely get easier with growth but much, much harder in its absence. Reasonable people get this. They also know, intuitively, that the kind of growth we want won’t be delivered just by central bank adjustments to interest rates or short-term fiscal initiatives that bring forward demand from next year, only to have to give it back then. They are looking for more sustainable sources of growth. They want to see more genuine dynamism in the economy and to feel more confidence about their own future income. So in your deliberations today, a key question worth asking is: how do we generate more growth? Not temporary, flash-in-the-pan growth, but sustainable growth. How do we craft a credible, confidence-enhancing, narrative about growth? That’s actually what “reform” is about: making things work better for higher income and wellbeing. If there are some things of substance that you could agree on, it would be a step forward. Present here in the room you have the intellectual resources, the stakeholders, the leadership and the communication capabilities. In short, you have the ingredients. Over to you. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 8 |
Opening statement by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Senate Economics References Committee Inquiry into matters relating to credit card interest rates, Sydney, 27 August 2015. | Malcolm Edey: Opening statement to the Senate Economics References Committee Inquiry into matters relating to credit card interest rates Opening statement by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, to the Senate Economics References Committee Inquiry into matters relating to credit card interest rates, Sydney, 27 August 2015. * * * Thank you for the opportunity to appear today. I know the Committee is interested in a number of different aspects of credit card pricing and regulation, and we’ve tried to address those aspects that come within our field of expertise and responsibility in our submission. As we explain in the submission, credit cards have both a payment and a credit function. The regulatory powers and mandate of the Reserve Bank Payments System Board (the Board) relate to the payment function. The Board has a mandate to use its powers to promote efficiency and competition in payment systems, consistent with overall stability of the financial system. To that end, the Board has for a number of years regulated card payment systems by setting standards in relation to such matters as interchange fees, surcharging and access. As you know, the Board is currently undertaking a comprehensive review of those aspects of card payments regulation. I’ll be happy to answer any questions you might have today about how that review is proceeding. I know the Committee is also very interested in the credit function, and particularly the interest rates on credit cards. That is not something that we regulate, but we have set out in our submission an overview of some of the key facts. If I may, I’ll just make a few high-level observations about that before we go to questions. Credit card products vary a lot in the interest rates that they charge. Some of those rates are very high. They’re higher than I think can be easily explained. Interest rates of the order of 20 per cent on credit cards are not uncommon. The average rate for borrowers who incur interest on credit cards is currently about 17 per cent. After deducting banks’ cost of funds and the cost of credit losses, that would equate to an interest rate margin of more than 10 percentage points. My advice if you’re in that situation is to shop around. Despite the prevalence of high-rate cards, this is a market where there is some significant competition. There are a lot of card products that offer lower rates and special deals for balance transfers. In many cases, cardholders should be able to lower their interest rates by taking advantage of those offers, if they are willing to shop around. That of course raises questions about why more cardholders don’t take advantage of the lower rates that are on offer, whether there are obstacles to competition and whether there might be some role for regulatory action. Some cardholders might be unable to switch, for example if they have poor credit histories. That is something that can be looked into, along with the related question of whether there are unreasonable obstacles to switching. Other cardholders might not be aware of the options available, or might have other reasons for not pursuing them. We discuss some of those issues in our submission. The answers to these questions are not necessarily straightforward, and I think these are areas where the financial regulators can usefully do further work. When I appeared at this Committee in June I indicated that the Bank would consult with other regulators in this area, BIS central bankers’ speeches and we have begun doing that. We will be continuing those discussions at a more senior level at the next meeting of the Council of Financial Regulators in September. I don’t want to pre-empt what might come out of those discussions, but some of the questions that might be considered are: whether there is a case for improved disclosure in this area; whether there is a need for stronger risk assessment requirements for credit card lending; and to what extent any actions in these areas would fall within the regulators’ existing powers and mandates. With that, my colleagues and I are happy to take your questions. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 8 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Actuaries Institute "Banking on Change" Seminar, Sydney, 16 September 2015. | Guy Debelle: Bond market liquidity, long-term rates and China Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Actuaries Institute “Banking on Change” Seminar, Sydney, 16 September 2015. * * * I am going to talk about three key current issues in financial markets, namely bond market liquidity, long-term interest rates and China’s exchange rate regime. All three are having an important bearing on financial market prices round the world, including here in Australia, both now and probably for quite some time to come. They may not sound that interrelated but I will tie them together at the end. Bond market liquidity I will start with bond market liquidity. If you have read any financial market media over the past year, you would have been hardpressed to avoid reading an article on bond market liquidity. Indeed, one of the best financial market commentators, Matt Levine, devotes a section of his column to “people are worried about bond market liquidity”. 1 Notwithstanding the fact that his column is published daily, he has little problem in finding material to write about on this issue. So today, I would like to provide Matt Levine with some more material and throw my hat into this crowded ring. Though not for the first time, as about a year ago I talked about this very issue. 2 So why revisit this issue again today? Here are a few reasons: First, one year on, there have been a few noteworthy liquidity “events” in the bond market, including the awkwardly named “Flash Rally” in US Treasuries on 15 October 2014, the day after I gave the speech last year. Second, the much anticipated first increase in the Fed funds rate has been designated as a critical test case of the state of liquidity in the bond market. Third, while equity markets experienced a volatile month in August, bond markets were, somewhat surprisingly, relatively stable (as for that matter, were major foreign exchange rates). That serves to highlight the fact that liquidity and volatility are related but are not the same thing. So what exactly do I mean by bond market liquidity? Generally I would take it to mean the ability to transact in the bond market without having a material influence on the price. For example, if I want to sell some of my holdings of Australian Government securities, how much will I be able to sell, and over what time period, without having a significant impact on market pricing? This question highlights two points: there is both a quantity dimension and a time dimension to liquidity. If I try to sell all my securities at once, my impact on the market is likely to be larger than if I break my order up into smaller pieces and sell it over a period of time. However, if I do the latter and sell gradually, there is a risk that the market price moves against me over that period of time, because of news or other people’s transactions and I don’t get as good an overall price. See for example, <http://www.bloombergview.com/articles/2015–06–03/people-are-worried-about-bondmarket-liquidity>. Of late, there has also been the occasional column on people who are not worried about bond market liquidity. “Volatility and Market Pricing”, speech to Citi’s 6th Annual Australian and New Zealand Investment Conference, Sydney, 14 October 2014. BIS central bankers’ speeches The quantity and time element of liquidity is often conflated in the discussion of bond market liquidity. Hence you can hear that it is currently simultaneously the best of times and the worst of times for liquidity in the bond market. Bond market liquidity at the “top of book” is, on a number of metrics, 3 as good as it has ever been. That is, my ability to sell a small parcel of bonds very close to the current market price is very good. But the “depth of book”, my ability to sell a large parcel of bonds, is nowhere near as good, and worse than its been for quite some time. How can it be that we have both of these two developments? This outcome reflects the evolution of the market over recent years in response to technological changes, regulatory changes as well as institutional appetite for this activity. In terms of technology, there has been a significant increase in the share of electronic trading in bond markets. In the Australian market, we estimate that electronic trading accounts for around one-third of trading in the Australian government securities market (though it is considerably less in other domestic bond markets). In the US, the share of electronic trading is much higher, more than half of turnover. With the increased electronification of the market has come high-frequency trading firms. These firms are providing increased liquidity at the top of the book, but are not necessarily contributing to the depth of the book, given their preference to trade in small size, as well as in many cases, inability to trade in large size because of balance sheet constraints. They have contributed to lower transaction costs (in terms of the bid-ask spread) for small orders. But there are question marks around their resilience in times of market stress. The key structural change is the shift in market share from those who provide immediate and continuous liquidity and have the ability to warehouse risk to those who do the same but don’t have the capacity to warehouse risk. In this regard, the bond market has followed the well-trodden path of the equity market and later the foreign exchange market of increased electronic trading and increased participation by high-frequency traders (HFT). Not all would regard the “equitisation” of the bond market (or foreign exchange market for that matter) as a good thing. 4 The report recently released by the US authorities examining the “Flash Rally” in the US bond market on 15 October 2014 highlights some of the issues. 5 To remind you briefly what happened on that day. About an hour after a slightly weaker than expected US data release, 10-year US Treasury bond yields fell rapidly by 16 basis points in six minutes (that is the price went up, hence a flash rally) before reversing course and almost retracing that move over the next six minutes. If you had taken a well-timed coffee break over that 12 minutes, you would have been none the wiser that anything much had happened. The report was not able to come to any conclusions about what caused this to occur, though investigations are ongoing. But it does provide information about the structure of US treasury market through that time, including the share of high-frequency firms, or proprietary trading firms (PTFs) as the report calls them, in the market. One interesting fact is that one firm had a relatively high share of both sides of the market, in part because a sizeable share of trades was being done with itself. That is, it was buying and selling US treasuries with itself. Another noteworthy fact is that the price adjustment was smooth throughout, there was no gapping in See “Market-making and proprietary trading: industry trends, drivers and policy implications”, CGFS report no. 52, November 2014, for a discussion and analysis of various liquidity metrics. Available at <http://www.bis.org/publ/cgfs52.htm>. Michael Lewis’s ‘Flash Boys’ brought high-frequency trading in equities into popular discourse. For the role of HFTs in the foreign exchange market, see ‘High-frequency trading in the foreign exchange market’, Markets Committee Publications No 5, September 2011. Available at <http://www.bis.org/publ/mktc05.htm>. See Joint Staff Report: The U.S. Treasury Market on October 15, 2014. Available <http://www.treasury.gov/press-center/press-releases/Documents/Joint_Staff_Report_Treasury_10–15– 2015.pdf>. at BIS central bankers’ speeches prices. So this event does not fit neatly into the category of a liquidity event. There was no prolonged dislocation where the price gapped rapidly and stayed there, which is often what people have in mind when thinking about the consequences of lower liquidity. Nevertheless, the fact that such events can occur in arguably the most deep and liquid market in the world does mean that we need to understand what is going on here. As well as the impact of technology, regulation has also had a significant effect. Regulatory changes have increased the cost to banks of intermediation, and hence liquidity provision, in many markets, and particularly the bond market. This has seen a number of participants withdraw completely and others scale back their activities. Bond desks at banks hold less inventory than they have done historically, given the increased cost of doing so. This contributes to less “depth of book” liquidity, though not necessarily less “top of book” liquidity. The regulatory changes were intended to have this effect. Liquidity provision was underpriced previously and was over-supplied. Regulation has increased the cost of providing liquidity and hence decreased the quantity supplied. So the direction of change should not be the issue, rather the extent of the change should be the focus of debates about bond market liquidity. That is, has regulation increased the cost of liquidity provision too far with the result that liquidity in the bond market is now too low? That is certainly a discussion worth having. But in the meantime, liquidity in the bond market today is what it is. It continues to evolve but it is not going back to what it was any time soon. So participants in the bond market need to adjust to the current situation rather than simply complain about it. If transaction costs are higher, particularly for transacting in large size, then asset managers and other bond holders need to take account of that in the way they execute their transaction in the market. For example, as discussed above, one solution may be to execute more slowly in smaller parcel sizes. Execution certainly needs to be more nimble and considered than in the past. But perhaps more importantly, the increased transaction costs in terms of liquidity and execution should also be taken into account in the way an asset manager constructs its portfolio. The differences in transaction costs across various classes need to be taken into account. If transaction costs are higher, then perhaps I should be transacting less. Do I really need to be selling? In some cases, I might not have much choice, because the need to transact may be driven by the mandate I have been given. But in that case, a discussion should at least be had with the provider of the mandate highlighting the higher transaction costs and the implications that has for the portfolio. Or maybe I need to transact because of redemption flows out of my fund. In that situation, I may need to think about holding a higher liquidity buffer than I did in the past. If the cost of obtaining liquidity in the market from my bond portfolio is higher than it used to be, then I need to think about weighing that up against the cost of holding more liquidity on my own balance sheet to accomodate potential redemption flows. Let me now turn to another concern that is often expressed around bond market liquidity, namely that, with the decline in intermediation by the banks, the likelihood of market dislocation is higher. This often comes up in discussions around the consequences of the Fed tightening monetary policy resulting in a large sell-off in bond markets. The “taper tantrum” of 2013 is often invoked as an example. This saw a rapid rise in bond yields in a number of emerging markets following indications that the Fed was going to wind down its quantitive easing program. As I said last year, I think the issue is not so much one of a decline in liquidity as much as a decline in the capacity to warehouse risk. In the past, when there was a large sell-off in bond markets, liquidity was never that great. A bank has no more desire than any other investor to catch a falling knife. Bid-ask spreads widen considerably and the depth of book deteriorates. That has always been the case. BIS central bankers’ speeches However, in addition to a decline in liquidity provision, banks now have less risk-warehousing capacity than they did in the past. They are less able to be nimble buyers of assets whose prices they believe have overshot. In the past, while the banks may have pulled back for a while as prices fell, they were generally among the first to step in and buy when they felt that the price had overshot. This is one important aspect of what I mean by warehousing or absorbing risk. As a result of regulatory changes as well as their own risk tolerances, they are less willing and able to do this today. Many real money investors are not able to move so quickly to take advantage of overshooting prices. The degree of discretion is generally not as large. Mandates often impose the constraint of not straying too far from benchmarks, and it takes a long time to change mandates to respond to changes in market circumstances. Are there other participants in the market who are able to move so rapidly and agilely to perform that function today? I’m sure they exist but I’m not so sure that there are enough of them. I suspect we will soon find out. If there is less capacity to do this, then prices will move by larger amounts and remain away from equilibrium values for longer. Volatility will be higher. In itself, this is not necessarily a bad thing. It is what it is. But with higher volatility, the distribution of price movements will have fatter tails. Overshooting will be more likely and that can have long-lasting and more deleterious consequences. Given that, some have recommended that central banks step in and play the role of marketmaker of last resort. Without debating the merits of that proposal today, it is worth pointing out that the term “market-maker of last resort” is misrepresenting the role being played here. A market-maker makes two-way prices, both buying and selling. In a dislocated market, with most of the trading one-way, the central bank would only be buying, it wouldn’t be selling the asset to anyone else anytime soon. A more appropriate description is buyer of last resort, with the risk to the central bank’s balance sheet that comes from performing that role. Long-term yields I will now talk a bit about an issue that is of direct relevance to actuaries. Is the government bond rate still the appropriate risk-free yield? Is it lower now than it used to be and will it stay there? On the first question, in my opinion, the answer is still yes. Ultimately the risk-free yield should be something that approximates the growth rate of the economy. On that basis, the government bond yield is still doing a pretty good job. Yes, policy actions in some of the major economies might have pushed the yield lower than it might otherwise have been. But those policy actions reflect the growth circumstance in which we find ourselves. In Australia, partly as a result of those policy actions, we have seen foreign holdings of Australian government securities increase to over 75 per cent at its peak, though it’s a bit lower than that now. Again, I don’t see these purchases as distorting the Australian government bond yield, but rather reflecting the reality of the world we live in. So with government bond yields around historical lows in recent years, should that be reflected in the discount rates used in actuarial calculations? How long is this period of low rates going to last? I’m not going to answer the question directly. But again it’s useful to think of it in terms of economic growth rates. Secular stagnation is often put forward as a reason why growth rates will be lower than they used to be. There are various theories of secular stagnation around, but a number of them boil down to the proposition that the rate of innovation and technological progress will be lower now and in the future than it has been in the past. Personally I find that very defeatist, and ultimately speculative. We simply don’t know what the future will bring. There have been quite a number of times in the past where such a claim has been made which has subsequently been proven wrong. Maybe it’s right this time, but I don’t see any reason to give up yet. BIS central bankers’ speeches In Australia, one factor which does have a significant influence on real growth rates is the rate of population growth. That has slowed in Australia of late, which means there are some grounds to believe that the medium-term growth rate of the economy has slowed, in which case discount rates should probably be lower. But the orders of magnitude we are talking about are pretty small, of the order of a quarter of a per cent. That is well within the range of error around our knowledge of the longer term growth rate of the economy. That said, I realise a quarter of a percentage point can matter a lot actuarially when compounded over a number of years. So to sum up, I continue to believe the government bond yield is the best measure of the risk-free yield in the economy. There are some reasons to believe that is now structurally lower than it used to be, but I find the proposition that the future rate of technological progress will be lower too pessimistic. China’s exchange rate I will just say a few words about the recent developments in China’s exchange rate, picking up on some of the points highlighted in the RBA Board minutes released yesterday, as well as my colleague Phil Lowe’s speech last week. 6 As you probably know, the Chinese authorities made a notable change to their foreign exchange rate regime on 11th August. On that day, the Chinese authorities moved the exchange rate regime further along the path to a more market-determined rate, a development which should be welcomed. The initial effect was for the Chinese exchange rate to depreciate by around 4½ per cent. This is not all that big in the general scheme of exchange rate moves (though it generated a very large amount of commentary). Moreover it comes in the context of a more than 15 per cent appreciation of China’s exchange rate in trade-weighted terms over the past year as the RMB moved up in lock-step with the US dollar. I want to focus here on one aspect of the change in the regime. As part of their efforts to limit the appreciation of the RMB over more than a decade, the Chinese authorities had accumulated US$ 4 trillion in foreign exchange reserves. This occurred in an environment of a sizeable current account surplus combined with significant flows of capital into China as well as stringent restrictions on the ability of Chinese citizens to invest abroad. However, that environment has changed, China still runs a current account surplus, though it is smaller than it was a few years back. Most importantly, China is now experiencing sizeable capital outflows as the easing of restrictions on capital flows has allowed Chinese citizens to invest abroad. As a result, the Chinese authorities have of late, in the face of these capital outflows, been intervening to hold up their exchange rate, rather than hold it down. Consequently, China’s foreign exchange reserves have declined by around half a trillion US dollars. We don’t know what the Chinese are selling because we don’t know the composition of their reserve holdings. But it probably involves some US treasuries and other sovereign bonds. Nor do we know what assets the private capital outflow from China is buying. But they are both huge orders of magnitude are most certainly having a first order influence on financial markets. One can regard the Chinese reserve accumulation as reflecting the accumulation of foreign assets by the state on behalf of the private sector who couldn’t invest abroad. Now the private sector can invest, there will be a switch as they accumulate assets while the public sector sells down its holdings. That is, a fair part of what is going at the moment is a shift in who is holding foreign assets in China, not necessarily a large change in the total quantity of “International and Domestic Adjustment”, speech by Philip Lowe at a Committee for Economic Development of Australia (CEDA) event, Melbourne, 9 September 2015. BIS central bankers’ speeches foreign assets being held by China. What matters for global financial markets is the difference in portfolio allocation between the public and private sector in China. Conclusion I have talked about three topical issues in financial markets today: bond market liquidity, long-term yields and China’s exchange rate. All three issues are important to financial markets in Australia. They are currently quite interrelated, with the rundown in China’s foreign exchange reserves probably in part comprising sales of US treasuries and other sovereign bonds, because of their greater liquidity, thereby affecting global long-term yields. We are seeing an unusual situation where a risk-off environment is associated with sales of the risk-free assets by a large market participant, rather than purchases. On bond market liquidity, the decline in liquidity is, in part, a desired outcome of regulation. Whether it has fallen too far can be debated. But the situation isn’t going to change any time soon. Market participants have to adjust their behaviour to deal with the current state of affairs. They have to consider carefully how their execution strategies will function in an environment of lower liquidity and they may also need to adjust the construction of their portfolios accordingly. Whether the changed market environment is more conducive to temporary flash crashes or permanent dislocations remains to be seen. The latter is of significantly greater concern than the former, which can be avoided by a well-timed coffee break. All three of these issues are going to be with us for a while to come. So it is important we adjust to the current environment rather than wish it was something else. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 9 |
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA), Melbourne, 9 September 2015. | Philip Lowe: International and domestic adjustment Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Committee for Economic Development of Australia (CEDA), Melbourne, 9 September 2015. * * * Accompanying charts can be found at the end of the speech. I would like to thank Tim Atkin and Kevin Lane for assistance in the preparation of this talk. I would like to begin by thanking the Committee for Economic Development of Australia (CEDA) for the invitation to address this lunch. It is a pleasure to be able to speak at another CEDA function, particularly one here in Melbourne. A central theme of the Reserve Bank of Australia’s (RBA) communication over the past few years has been that the Australian economy is in a period of transition: a transition from the biggest resources boom in over a century to something a bit more normal. The sheer scale of the resources boom means that this transition has its challenges. And these challenges are being compounded by what is happening beyond our shores. A second theme of our communication, however, has been that a reasonably successful transition is possible, and indeed, probable. This assessment reflects the positive fundamentals of our economy, as well as its underlying flexibility. This flexibility helped us deal with the upswing of the resources boom and is now helping us deal with the downswing. And a third theme of our communication has been that monetary policy is helping this adjustment, but that the likelihood of a successful transition would be boosted by a lift in underlying productivity growth and an increase in the expected risk-adjusted return on capital formation – both physical capital and human capital. Today, I would like to take this opportunity to touch on each of these three themes. I think it is useful to start with recent developments in the global economy, particularly in China, as they form an important backdrop to the adjustment that we are going through. And then I would like to focus on the ongoing adjustment in our own economy. Global developments So, first to the global backdrop. Perhaps the main news over the past month or so is that from China. In particular, two developments in Chinese financial markets have caught people’s attention. The first is the very sharp decline in the Chinese equity market and the second is the decision by the Chinese authorities to allow the renminbi to depreciate against the US dollar. In the Chinese equity market, prices have fallen by almost 40 per cent since mid June (Graph 1). This fall has reversed around two-thirds of the increase that occurred over the previous year. The reasons for this earlier increase are not entirely clear. One possible factor was an easing of some restrictions on margin financing. Another was an expectation by Chinese citizens of future capital gains, perhaps as the equity market opened up to increased investment from overseas. A third was the weakness in residential property markets. Whatever the reason, as so often happens, things went too far. Many investors thought the increase in equity prices would keep going and many borrowed money to get a bigger stake in what was a rising market. A bubble developed. And then it burst. While this attracted much attention, these movements in the Chinese equity market are likely to have only limited implications for the overall Chinese economy. In terms of the exchange rate, for much of the past few years, the renminbi has moved closely with the US dollar (Graph 2). This meant that as the US dollar appreciated, so too did BIS central bankers’ speeches the Chinese currency; on a trade-weighted basis, the renminbi had appreciated by around 15 per cent between mid 2014 and the end of July this year. With the US and Chinese economies being in different phases of the business cycle, it is unsurprising that the Chinese authorities might have come to the conclusion that greater flexibility of the renminbi against the US dollar was warranted. Notably, a move in this direction is also consistent with the authorities’ long-standing goal of transitioning to a more market-determined exchange rate. While the change in the Chinese exchange rate also attracted much attention, the magnitude of the change does need to be kept in some perspective. At around 3 per cent, the recent depreciation is hardly out of line with the shortterm movements that are sometimes seen among the major freely floating currencies of the world. These developments in the Chinese financial markets have coincided with signs of some further slowing in the Chinese economy. Many of the recent indicators – including those for industrial production, fixed asset investment and retail trade – have been somewhat softer than earlier in the year (Graph 3). The same is true for various business surveys and Chinese exports. In contrast, one area that has looked a little more positive of late is the residential property market. In some of the larger cities, property prices have been increasing again, although construction activity has yet to pick up noticeably. Over the past month, the news out of China has had significant ripple effects on global equity markets. Volatility has picked up and many of the major equity markets are down around 10 per cent from their levels a few months ago. Volatility has also picked up in commodity markets and most commodity prices are also lower than a few months ago. It is noteworthy though that this increased volatility in equity and commodity markets has not led to dislocation in other financial markets. In particular, there has not been a deterioration in funding markets and credit spreads have mostly moved in a relatively narrow range. This recent focus on developments in China has, understandably, thrown the spotlight on the outlook for the Chinese economy. Assessing this outlook is complicated by the fact that China is simultaneously adjusting to slower growth in potential output and dealing with a relatively soft phase of its own business cycle. The slowing in potential output growth – after an extraordinary period of sustained doubledigit growth – was inevitable and, indeed, widely expected. It has, however, brought into sharper focus some of the structural challenges facing the Chinese economy. These include: • the challenge of shifting from investment-led to consumption-led growth • the challenge of liberalising the markets for important factors of production – including labour, land, capital and energy • the challenge of demographic change, with the Chinese working-age population now declining and the overall population ageing • the challenge of dealing with various strains and distortions in the financial system and the property market. At various times the Chinese authorities have acknowledged each of these challenges and a range of plans has been developed to deal with them. However, how successful these plans ultimately turn out to be is yet to be seen. There is no doubt that the economic outcomes in China over the past few decades have been remarkable, with hundreds of millions of people being lifted out of poverty. The challenges, however, are not getting any easier, and the authorities’ recent handling of the stock market crash has led some to ponder the general direction of Chinese policy, including the likely pace of reform across the economy. This is an issue that will bear close watching over the months ahead. From a cyclical perspective, the Chinese authorities have taken a number of steps recently to support growth. Increased spending on infrastructure is one of these. Nominal benchmark BIS central bankers’ speeches interest rates have been reduced, although with inflation declining, real rates have tended to rise over the past year (Graph 4). Reserve requirements in the banking system have also been lowered, although this was designed to offset the withdrawal of liquidity that has taken place as the Chinese authorities have sold foreign exchange reserves in response to private capital outflow from China. The depreciation of the renminbi against the US dollar can also be expected to provide some support, at the margin, to the Chinese economy. So, overall, it is a complicated picture at present in Australia’s largest single trading partner. We became used to extraordinarily strong growth in China and now we are having to get used to something a little less extraordinary, and we are also being reminded that China too has a business cycle. Nevertheless, it remains the case that there are still significant mutually beneficial opportunities from deeper economic relations between Australia and China. As a nation, we need to keep an eye on these opportunities, while, at the same time, understanding and managing the associated risks as best we can. Elsewhere, the recent economic data have mostly had a slightly more positive tone. The US economy is recording above-average growth and the unemployment rate is around most estimates of full employment. In Europe, the economic news has recently tended to be a bit better than it had been earlier in the year and a recovery, of sorts, is taking place there. In India, too, the growth momentum looks to have improved, although in a number of countries in east Asia, both domestic demand and export growth have slowed. For the globe as a whole, economic conditions continue to be supported by the decline in oil prices. In addition, the drag from fiscal consolidation has lessened in several countries. Monetary conditions also remain very accommodative. At some point before too long, we should hope that the US economy is sufficiently strong for the Federal Reserve to begin the process of normalising interest rates there. A stronger US economy should be good for the rest of the world, although financial market developments will need to be watched carefully given that the policy interest rate in the United States has been at zero for almost seven years now. Putting all this together, when the RBA published its latest forecasts a bit over a month ago, we were expecting GDP growth in our trading partners to be around average over the next couple of years (Graph 5). While recent news on global industrial production has been softer, on balance, the recent data have not changed this general outlook materially. We still expect GDP growth in our trading partners to average around 4 per cent over 2015 and 2016, although given recent developments in east Asia the risks around this central forecast are tilted a little to the downside. The domestic transition I would now like to turn to the adjustment in the domestic economy. The broad story here is well known. Over the past decade, Australia has experienced an extremely large external shock in the form of a resources boom (Graph 6). This shock has had three phases. The first phase was a very large increase in commodity prices. The second was a very large increase in resources sector investment. And the third phase is a very large increase in resources sector production and exports. While these various phases have overlapped at times, we are now very much in this third phase, in which higher production is generating increased exports, but commodity prices are much lower than they were a few years ago and resources sector investment is returning to more normal levels. During the first two stages there was a significant reallocation of resources within the Australian economy. This was important in avoiding the overheating that had characterised BIS central bankers’ speeches previous resources booms. But an adjustment back the other way is now taking place, and has been for some time. Indeed, the terms of trade have been declining for almost four years now, after having peaked in the second half of 2011. Over this period, the global supply of commodities has increased substantially as new investment projects have come on stream over the past four years. Largely as a result, the prices of our exports relative to our imports have fallen by around 30 per cent. This decline brings the terms of trade back to around their level in the mid 2000s, which was considerably higher than their average of the 1990s. The peak in mining investment occurred around a year after the peak in the terms of trade. In mid 2012, mining investment reached a record high of around $30 billion per quarter. Since that time, it has fallen significantly to be around $20 billion in the June quarter this year. Further declines still lie ahead as more projects are completed, although the end of these large declines now looks to be coming into sight; our current forecasts have mining investment declining to around $10 billion per quarter by the end of 2017. If this does turn out to be the case then we are currently roughly halfway through the decline in mining investment. In contrast, the ramp-up in resources sector output is still under way. Over the past three years, resource exports are up by 20 per cent and annual increases of around 9 per cent are expected over the next couple of years as LNG production increases. While there is inevitably a degree of imprecision in the estimates, this increase in LNG exports is expected to boost GDP growth by an average of around ¾ percentage point in each of 2016 and 2017. Through this third phase of the mining boom, the economy overall has been growing at an annual rate of between 2 and 2½ per cent (Graph 7). The quarterly readings for GDP continue to be affected by fluctuations in mining production due to the weather. But looking through this volatility, the data for the June quarter suggest that the economy is continuing to grow at a similar rate to that of the past few years. Most other recent indicators are also consistent with a moderate expansion in the Australian economy. Measures of business conditions have improved and most are now above average. The unemployment rate has been little changed over the past year and the demand for labour has increased, with a rise in employment relative to the working-age population. The housing cycle remains in an upswing and household consumption is growing moderately (Graph 8). For many in the community, the fact that growth is occurring at only a moderate pace is disappointing. Growth has been slower than we had become used to, and slower, I think, than we are capable of. And, in terms of our incomes, this has been compounded by the decline in prices of resource exports. As a result, there has been very little growth in our real income per capita for some years now, after a decade and a half of very strong growth. While this disappointment is understandable, we should not lose sight of the fact that our economy has shown considerable ability to adjust, and to do so in a way that has preserved both overall economic and financial stability. We have adjusted to the upside of a huge positive international demand shock without overheating and we are now adjusting to the downside while still managing to grow at a moderate rate. This is a significant achievement and is a testimony to the underlying flexibility of our economy. This flexibility should give us come confidence about the future. An important element of this flexibility is the exchange rate (Graph 9). When the terms of trade initially started to fall and the decline in mining investment was clearly in sight, the exchange rate was relatively slow to adjust. On a number of occasions, the RBA drew attention to this. But the exchange rate has now adjusted considerably and this adjustment has continued over recent weeks. Just as the appreciation helped stabilise the economy in the upswing of the boom in commodity prices and mining investment, the depreciation is helping in the downswing. BIS central bankers’ speeches One example of this is in the tourism industry. As the relative cost of overseas travel has increased, more Australians are holidaying domestically and more people are visiting our shores. Encouragingly, we are now seeing some signs that this change in travel patterns is prompting a pick-up in investment in the tourism industry. In particular, there has been a noticeable increase in the stock of work to be done in the construction of hotel and related accommodation (Graph 10). The RBA’s liaison with tourism-related businesses suggests that further increases in investment in this area are likely in coming years. Conditions have also improved in a number of other sectors that are sensitive to the exchange rate. Another element of the flexibility has been the labour market, both in terms of labour supply and wages (Graph 11). During the upswing, population growth picked up noticeably, partly due to a rise in immigration. This helped alleviate some of the pressures in the labour market that would have otherwise occurred, especially in areas where skills were in short supply. In the downward phase, population growth has slowed, again partly due to immigration. Aggregate wage growth has also moderated significantly. This has played some role in generating sufficient employment growth over recent times to keep the unemployment rate steady despite the below-average growth of the overall economy. A third element of this flexibility has been monetary policy. As the RBA has frequently noted, it is entirely appropriate that, during a period in which both the terms of trade and mining investment are declining, monetary policy is accommodative. Monetary policy is helping support growth in the overall economy even if it is not working in quite the same way as it once did. This support is most clearly evident in the interest-sensitive housing construction sector, where investment has increased by 7 per cent over the past year. The stronger housing market is also having some positive ripple effects on parts of the retail sector. So, together, the flexibility of the exchange rate, the labour market and monetary policy is helping with the cyclical adjustment in our economy. The missing ingredient continues to be a lift in non-mining business investment, where we are still waiting for convincing signs of a pick-up. The latest reading from the Australian Bureau of Statistics on firms’ capital spending plans outside the resources sector did show a slight improvement from earlier readings, but a material lift in non-mining business investment still seems to be some way away. In time, though, we should expect that the adjustments that we have seen in the cyclical variables – the exchange rate, the labour market and interest rates – will help create the environment that leads to increased investment. But there are clearly limits here. A low exchange rate, low growth in wages and low interest rates are not the basis for sustained increases in investment and output. They can certainly help during the adjustment phase, but ultimately we will be better off if increased investment is driven by high expected returns rather than by the low cost of finance or low wages. This is why the focus on improving the climate for business investment is so important. There is no magic bullet here, but surely the investment climate would be improved through a strong focus by both business and government on innovation, productivity, human capital and entrepreneurship, topics that I have spoken about on previous occasions. Thank you and I would be happy to answer any questions that you might have. BIS central bankers’ speeches Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches Graph 5 Graph 6 BIS central bankers’ speeches Graph 7 Graph 8 BIS central bankers’ speeches Graph 9 Graph 10 BIS central bankers’ speeches Graph 11 BIS central bankers’ speeches | reserve bank of australia | 2,015 | 9 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 18 September 2015. | Glenn Stevens: Overview of recent economic developments in Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Canberra, 18 September 2015. * * * Chair Members of the Committee Thank you for the opportunity to meet with you today. The Australian economy continues to progress through a major adjustment, in the midst of testing international circumstances. The terms of trade have been falling for four years and have declined by a third since their peak – though that was a very, very high peak. They are now back to about the same level as in 2006 – still about 30 per cent above their 20th century average level. Resources sector capital spending has been following the terms of trade with a lag. From an extraordinarily high peak – at about 8 per cent of GDP, nearly three times the peaks seen in most previous upswings – this investment has been falling for about two and a half years. By the time it is finished, this decline will probably total something like 5 per cent of GDP. We are probably now about halfway through the decline. It is having a predictable impact on those industries and regions that had earlier experienced the effects of the boom. Resources sector exports have risen strongly as the greater capacity resulting from all the investment has been put to use. Australia now exports around three times the volume of iron ore that it did a decade ago, and around twice as much coal. A very large rise in exports of natural gas is in prospect over the next few years. Outside the mining sector and parts of the economy most directly exposed to it, there are signs that conditions have been very gradually improving. Survey-based measures of business conditions have been a bit above their longer-run average levels for some time now, and the most recent readings are about where they were in 2010. A few of the nonmining sectors have shown quite marked improvements over the past twelve months. To this we can add that the overall number of job vacancies in the economy has been increasing, even as employment opportunities in mining and some other areas diminish. The increase has not been rapid, but nonetheless the trend has clearly been upward for about two years. Since this time last year, moreover, we have seen a rise of about 200 000, or about 2 per cent, in employment. The labour force participation rate and the ratio of employment to population have both started to increase. The rate of unemployment, though variable from month to month, seems to have stopped rising, and it is at a level a bit lower than we had thought, six months ago, it might reach. Of course, this performance is not uniform geographically or by industry. The two large south-eastern states show the largest increases in demand and employment, and dwelling prices, while conditions elsewhere are more subdued. By industry, the rise in employment has been strongest in services, especially those types of services delivered to households, though business services activities have also added to employment over the past year. Monetary policy is seeking to support this transition, something it can do because inflation remains low. Very low interest rates, coupled with financial institutions wanting to lend, have played a part in the improvement in conditions in some sectors. Residential construction is running at very high levels, households are adding a little less of their incomes to savings and savers have been searching for higher returns. These are all indications of easy money at work. Cognisant of the risk that very low interest rates may foster a worrying debt build-up, regulatory initiatives are in place to maintain sound lending standards and capital adequacy. I BIS central bankers’ speeches hasten to add that the objective of such tools is not to control dwelling prices, but to contain leverage. The evidence is emerging that they are doing their job. More recently, the significant decline in the exchange rate is starting to have more discernible effects on the pattern of spending and production. The decline over the past two years amounts to about 25 per cent against a rising US dollar and 18 per cent against the trade-weighted basket. We are hearing about the effects of this in our liaison and also seeing it in the data on such things as tourism flows as well as exports of business services. This is to be expected as the exchange rate adjusts to the change in the terms of trade. Over the year to June, real GDP grew by 2 per cent. This was in line with our forecast of three months ago and at the lower end of our forecast range from a year ago. The effect of unusual weather conditions on exports meant that GDP as measured exaggerates both the strength in the March quarter and the weakness in the June quarter. There are still some puzzles in reconciling what has happened to real GDP with what has happened to employment and indications from business surveys. Hopefully, those puzzles will be resolved over time. Nonetheless, what is pretty clear is that the economy is growing, albeit not as fast as we would like, the adjustment to the decline in the terms of trade is well advanced, and nonmining activity is improving rather than deteriorating. If the latter trend continues, it is credible to think that we can achieve better output growth, particularly as we reach the later phases of the decline in mining investment. This is what is needed to bring down the unemployment rate. As always, global factors will be important and the international setting continues to be a rather complex one. Since the last hearing, growth in the Chinese economy has continued to moderate. Growth in other parts of Asia was also weaker around the middle of the year. Reflecting these outcomes, forecasts for global growth over the period ahead are a little lower than they were six months ago. That was the backdrop for a period of volatility in some financial markets. The unwinding of an equity market bubble in China appears to have served as the proximate trigger for a revision of equity valuations around the world. Risk appetite diminished somewhat and the currencies of many emerging market economies came under downward pressure. Whether that financial volatility itself will serve further to dampen global growth prospects remains to be seen. Sometimes such events portend a wider set of economic events, but just as often, they don’t. In the present instance, it is important to stress that long-term debt markets and core funding markets for financial institutions have not been impaired. These markets remain open and it is still the case that highly rated private borrowers and most sovereigns can borrow at remarkably low cost. Things could change, but at present we do not see anything approaching the dislocation of funding channels seen in serious crises. To be sure, emerging market countries are under some pressure and some of them have specific problems that are being recognised by markets. At the same time, though, many emerging market countries have done quite a bit to improve their resilience over the years. It’s also worth noting that performance in the Unites States continues to improve. Everyone knows that, eventually, this will have to be reflected in less accommodative US monetary policy. Some fretting about the first increase in US interest rates for nine years is to be expected, no matter how well telegraphed it has been. The more important factor, though, will be the pace of subsequent increases. The Federal Reserve has indicated this is expected to be very gradual, but of course that will depend on what happens with the US economy. There is a degree of irreducible uncertainty here and hence the possibility of further financial market volatility at some point. Overall though, it seems very likely that global interest rates will still be quite low for quite some time yet. BIS central bankers’ speeches For Australia, we cannot, of course, determine our terms of trade or other forces in the global economy. We can only adjust to them. The record of adjustment in recent years is good. We negotiated the financial crisis without a major financial crisis of our own or a big downturn in economic activity. We negotiated the first two phases of the resources boom without major inflationary problems, and are part way through our adjustment to the third phase – so far without a major slump in overall economic activity. There is still a pretty good chance that we will come out of this episode fairly well, and much better than we came out of previous episodes of this type. I now turn briefly to another area of the Bank’s responsibilities, namely the payments system. The New Payments Platform (NPP) will enable real-time, data-rich payments on a 24/7 basis for households, businesses and government agencies. The Payments System Board, having worked to facilitate the process of the private sector coming together to drive this project, supports the industry’s efforts. The Reserve Bank itself is making good progress in its own part in this project. In the card payments area, the Bank has announced a review and we released an Issues Paper in early March. Among other things, the review contemplates the potential for changes to the regulation of card surcharges and interchange fees. It provides an opportunity to consider some of the issues raised in the Financial System Inquiry. As usual, the Bank has been consulting widely, including via a roundtable in June that included representatives from over 30 interested organisations. The Payments System Board has asked the staff to liaise with industry participants on the possible “designation” of certain card systems. A decision to designate a system is the first of a number of steps the Bank must take to exercise any of its regulatory powers in respect of a payment system, but does not commit it to a regulatory course of action. The Payments System Board will have further discussions on the case for changes to the regulatory framework at future meetings. In the event that the Board were to propose changes to the regulatory framework, the Bank would, as usual, undertake a thorough consultation process on any draft standards. In our financial stability role, a focus has been on central counterparties, which facilitate efficient and safe clearing of some types of financial transactions. These entities are increasingly important given the way global regulatory standards have been moving. The Bank has focused on ensuring their risk management meets the highest standards and that they have the capacity to recover from financial shocks. We have also done a lot of work to ensure that our regulatory framework is appropriately recognised by regulators in other jurisdictions, which is important if we are to keep the Australian financial system connected with the global system. With those remarks, Chair, my colleagues and I await your questions. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 9 |
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the International Swaps and Derivatives Association's (ISDA) 2015 Annual Australia Conference, Sydney, 22 October 2015. | Malcolm Edey: The transition to central clearing of OTC derivatives in Australia Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the International Swaps and Derivatives Association’s (ISDA) 2015 Annual Australia Conference, Sydney, 22 October 2015. * * * I thank Mark Manning for his invaluable assistance in preparing these remarks. Good morning and thanks to ISDA for the opportunity to speak here today. When I last addressed this forum three years ago, it was a time of quite significant stress in world financial markets. A particular focus of concern was the unfolding crisis in Greece and the associated risk of spillovers to other parts of Europe. A lot has happened since then. As a general observation, financial conditions around the world have been gradually recovering, though not without some periodic bouts of nervousness. The concerns about Greece came to a head around the middle of this year, and spillovers from that have turned out so far to be quite limited. More generally, the world economy has been expanding at a reasonable pace over these three years, and the process of balance sheet repair has continued. These are positive developments. Nonetheless, in some important respects the situation is still some way from returning to normal. The after-effects of the global financial crisis are still weighing on activity in some of the major economies. And interest rate settings around the world are still at exceptionally low levels to support growth, seven years after the crisis reached its height. All of this underscores the point that financial crises are costly events. They are costly in terms of lost income and output, lost jobs and damage to institutions. And we’ve seen again that it takes a lot longer to recover from a financial crisis than it does from other types of economic downturn. These are good reasons for the global efforts that have been made over the past few years to build resilience in our financial systems. A great deal of work is underway on that front, at both national and international levels. In Australia, we have had a major inquiry into the financial system which, as one of its priorities, made a number of recommendations to strengthen financial resilience. Key recommendations in that area have been endorsed by the government this week. Internationally, there has been an extensive program of regulatory reform initiated by the G20 and coordinated through the international standard setting bodies. Today I want to focus on just one aspect of that work, namely the move to central clearing of over-the-counter (OTC) derivatives. As you know, this was initiated by the G20 commitments made at the Pittsburgh Summit in 2009 1. While progress on those commitments has been slower than many would have liked, a lot has been achieved. In my talk this morning, I would like to review what has been achieved so far, highlight some of the key considerations in implementation, and look ahead to some of the work that remains to be done. Specifically, G20 leaders agreed that “all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivatives contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements”. BIS central bankers’ speeches What has been achieved? When I spoke at this conference in October 2012, the Australian Council of Financial Regulators (the Council) had provided its advice to the government following on from the G20 commitments, and the legislative response to that advice was well underway. The resulting amendments to the Corporations Act came into force at the beginning of 2013. These gave the responsible minister the power, on the advice of the regulators, to determine particular products for mandatory trade reporting, central clearing or platform trading. They also gave ASIC the power to elaborate on the details of any such obligations by setting derivative transaction rules. As I foreshadowed then, the immediate priority once the legislation came into effect was the introduction of a broad-based trade reporting requirement. That regime is now fully in force for all but the smallest derivatives market participants. Given its mandate for financial stability, the Reserve Bank’s primary interest has been in central clearing, and it has worked closely on this with the other council agencies. Initially the agencies favoured an incentives-led transition to central clearing. But for a number of reasons, including considerations of international consistency, the council ultimately turned its attention to a mandated approach. An important initial step was to establish a framework for assessing the case for any mandatory clearing obligations. That framework was applied in the regulators’ published reports on the Australian OTC Derivatives Market in July 2013 and April 2014. Together, these reports made recommendations to the government to proceed with clearing obligations for interest rate derivatives in Australian dollars and four major global currencies. 2 As most here would know, just a few weeks ago, the government issued a determination consistent with those recommendations. The government also released amendments to the Corporations Regulations 2001 restricting the institutional scope of the regime to internationally active dealers. ASIC is now in the process of finalising its derivative transaction rules in response to feedback from the recent consultation. These rules will set out further details of the mandatory clearing requirement including how the mandate will apply to cross-border transactions, the use of overseas CCPs to meet the mandate, and the effective commencement date in 2016. Key considerations in implementation The implementation of a mandatory clearing obligation in Australia has involved a number of important considerations. The aim throughout has been to ensure that the financial stability benefits of central clearing are achieved, while supporting effective market functioning and keeping the Australian market globally connected. I would like to discuss in more detail how the regulators have sought to achieve this. Ensuring that the stability benefits are achieved Central clearing potentially offers a range of well-known benefits. They include: centralised and standardised risk management; reduced counterparty risk exposures due to multilateral netting; a less complex and more transparent ‘hub and spokes’ network of exposures; coordinated default management; and operational improvements and efficiencies. CCPs also provide a focal point for regulation and oversight. These benefits are likely to be greatest for products that are traded widely and which give rise to sizeable counterparty exposures when they are not centrally cleared. In the Australian context, the regulators have identified Australian dollar-denominated interest rate swaps, and The US dollar, euro, British pound and Japanese yen. BIS central bankers’ speeches swaps denominated in the major currencies, as having these characteristics. These products were therefore prioritised in the regulators’ recommendations. The trade-off, of course, is that CCP clearing concentrates risk in just one (or a few) systemically important entities that might be critical to the functioning of the financial system as a whole. This has always been recognised in the debate. But, as the share of activity that is centrally cleared has risen, this dependence has attracted increasing attention. It is critical that these entities are highly resilient to shocks, operate on a continuous basis, and maintain the confidence of market participants. Recognising this, in 2012, the relevant international standard-setting bodies 3 published an enhanced set of standards for CCPs and other critical facilities called the Principles for Financial Market Infrastructures (PFMI). As the title indicates, the standards are principles based, and they have broad coverage. They establish requirements in all areas of CCP design and operation: legal and governance arrangements; credit and liquidity risk management; settlement; default management; general business risk and operational risk management; and access, efficiency and transparency. The PFMI have been adopted internationally and an extensive peer review process, co-chaired by the Reserve Bank, is underway monitoring the implementation measures that have been taken. In Australia, the Bank has included the stability-related principles in its Financial Stability Standards and has found them to be a sound basis for supervisory dialogue on risk matters. Application of the principles has been a catalyst for a range of enhancements in the risk management practices of the CCPs under the Bank’s supervision. ASIC has addressed other aspects of the principles in its supervision and policy setting activities, including by setting out ASIC’s expectations of how licensed CCPs should comply with their licence obligations. Given the particular importance of continuity of service, a key focus of the debate has been on what might be called ‘Plan B’; that is, how to ensure that, if a severe stress event threatened the viability of a CCP, it could continue to operate uninterrupted. There are two strands to the work in this area: recovery, which refers to actions taken by the CCP itself in a stress event; and resolution, which refers to actions taken by a resolution authority within the framework of a special regime to restore viability. The principles require that the tools and powers available to a CCP in recovery allow for any residual losses and liquidity shortfalls to be allocated comprehensively. So in principle, if a CCP in stress was able to implement its recovery plan in full, resolution should never be necessary. A special resolution regime is nevertheless an important back-stop. Resolution actions might be called into play if a CCP faced challenges in executing its recovery plan without public intervention, or if there were stability grounds for the resolution authority to intervene. It is expected that the starting point for a resolution authority would be the CCP’s own recovery plan. A number of jurisdictions, including Australia, are now developing special resolution regimes for CCPs and other FMIs in accordance with an agreed international framework developed by the Financial Stability Board (FSB). 4 In Australia the government consulted on a proposed regime in the first half of this year. Under the proposal, the Reserve Bank would be the resolution authority for domestically incorporated and domestically licensed CCPs and securities settlement facilities. Its mandate would be to pursue the overarching objective of financial stability and an additional key objective of continuity in the provision of critical services. In this week’s response to the Financial System Inquiry, the government agreed to progress additional measures in this area. The Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO). This framework is set out in the FSB’s Key Attributes of Effective Resolution Regimes (ref). BIS central bankers’ speeches Supporting market functioning In implementing all these reforms, the Australian authorities have been careful to intervene only where necessary, so as to preserve appropriate incentives and avoid imposing unnecessary costs on industry participants. This was reflected in the initial preference for industry-led solutions that relied on private incentives. The Bank and the other regulatory agencies took the view that an industry-led approach would allow the transition to occur in a measured way, and would avoid unnecessarily interfering with commercial outcomes. The decision, ultimately, to recommend a mandated approach, and the government’s acceptance of that advice, were driven importantly by considerations of international consistency. In a number of cases, products had already been mandated for clearing in other jurisdictions, notably interest rate derivatives denominated in the major currencies. The regulators took into account the benefits that could arise in such cases from favourable comparability assessments of the Australian regime, and from avoiding opportunities for regulatory arbitrage. These, of course, needed to be balanced against any possible adverse implications that regulatory intervention might have for market functioning. By the time they issued their recommendation in respect of interest rate derivatives in the major currencies, the regulators were confident that the industry had already made considerable progress in the transition to central clearing for these products. The incremental cost of regulatory intervention was therefore expected to be low. By April 2014, when the regulators also recommended that Australian dollar-denominated interest rate derivatives be centrally cleared, the Australian banks were already well advanced in becoming direct participants of the two licensed clearing services, LCH.Clearnet Limited (LCH.C Ltd) and ASX Clear (Futures). During the period since those recommendations were made, the transition to clearing among Australian banks has continued to accelerate, even though the clearing mandate has only recently been confirmed and has yet to take effect. Our liaison with Australian banks reveals that they are now centrally clearing almost all new trades that are eligible for clearing, and have also made considerable progress in backloading legacy trades into CCPs. All four major Australian banks are now active participants of both LCH.C Ltd and ASX Clear (Futures) and more than 40 per cent of Australian banks’ outstanding OTC interest rate derivatives across currencies has been centrally cleared via LCH.C Ltd (Graph 1). Graph 1 Click to view larger BIS central bankers’ speeches Both pricing and regulatory factors have contributed to this. Of course, the anticipation of a mandate being introduced has been an important factor. But more generally over time, a material pricing differential has emerged between cleared and non-cleared transactions, which has reinforced this trend. In the case of Australian dollar-denominated interest rate derivatives, the acceleration of Australian banks’ transition to clearing has contributed to an increase in total notional cleared to more than $5 trillion (Graph 2). 5 Since the regulators issued their recommendation, CME Clearing (CME) has also become licensed in Australia, although it currently has no direct Australian participants. It is not yet clear how the competitive dynamics in this area will evolve. Graph 2 Click to view larger Another important consideration for the regulators was the institutional scope of any clearing mandate. The government ultimately followed the regulators’ advice that the clearing mandates should apply only to internationally active dealers. This followed a survey, completed in early 2014, of non-dealers’ use of OTC derivatives. Overall, the regulators were not convinced of the public policy case to extend clearing mandates to non-dealers. They took the view that the contribution to systemic risk reduction might be limited, given the relatively small scale of non-dealers’ activity and their typical hedging motivation. There remained questions over access to appropriate clearing arrangements. And the international consistency motivation was also weaker. Reinforcing this conclusion, subsequent evidence suggests that non-dealers’ access to clearing agency services may be becoming more limited, with a number of instances of clearing agents stepping back from this business. Dealing with cross-border issues The third area I’d like to touch on is the cross-border dimension. Given the global nature of the OTC derivatives market, this has been a prominent part of the international policy debate. A The recent decline in cleared notional observed in Graph 2 represents compression activity. Compression is the practice of terminating offsetting trades in participants’ portfolios. BIS central bankers’ speeches particular focus has been the cross-border application of some jurisdictions’ rules, and arrangements for deference and cooperation among regulators. For a jurisdiction such as Australia, with a relatively small but highly globally connected financial sector, these things are particularly important. A key consideration has been to ensure that regulatory settings allow Australian institutions to remain globally connected. Another is to ensure that the desired outcomes are achieved without duplicating regulatory costs for market participants. ASIC has given considerable thought to these questions as part of its rulemaking on mandatory clearing. The Australian agencies have also worked closely with overseas regulators on the crossborder dimension. Let me give you a concrete example. In recent years, equivalence assessments of the Australian regimes in this area were undertaken by the European Securities and Markets Authority (ESMA). These assessments were used to determine whether the European authorities would allow Australian rules to apply, or would impose their own requirements on Australian institutions. In the case of CCPs, the Australian regime was given an unconditional positive assessment of equivalence by ESMA in late 2013. This ultimately led to recognition for the two CCPs in the ASX Group under the European Market Infrastructure Regulation. Similarly, in the United States, ASX Clear (Futures) recently became the first foreign CCP to obtain an exemption from registration as a Derivatives Clearing Organisation by the US Commodity Futures Trading Commission (CFTC). This was, effectively, recognition of the equivalence of the Australian regulatory regime, and it avoided a potentially costly duplication of requirements for that business. Of course, the mutual recognition process needs to work in both directions, and the Australian regulators have conducted similar equivalence assessments in cases where foreign CCPs have sought to offer their services here. In recent years, both LCH.C Ltd and CME have been licensed to offer services in Australia. In both cases, this occurred under provisions requiring the overseas regulatory regime to be deemed ‘sufficiently equivalent’ to that in Australia and supervisory cooperation arrangements to be concluded with the relevant overseas regulators. The resulting oversight regime maintains a broad equivalence of standards, avoids regulatory overlap and provides for deference to the home regulator. One other important aspect to be considered was the framework for domestic location requirements for systemically important facilities. Early in the policy process, a key question was the extent to which we should allow our domestic market to be cleared by an overseasbased CCP. After careful consideration, it was decided not to insist on domestic incorporation. Although a financial stability argument might be made for such a requirement, the regulators took the view that it could risk market fragmentation and might not be sustainable in a rapidly changing global market. Instead, the council has developed a graduated framework for imposing additional regulatory requirements depending on the importance of a cross-border CCP to the domestic economy and financial system. In 2013, LCH.C Ltd became the first CCP to be granted an overseas licence and to fall within the scope of this framework. LCH.C Ltd has since established operational and governance arrangements commensurate with the scale of its services to Australian participants. It has also established Australian dollar liquidity arrangements consistent with the requirements for a systemically important CCP, including opening an Exchange Settlement Account with the Reserve Bank. As part of the supervisory arrangements, the Bank is also represented on a global college for LCH.C Ltd, led by the Bank of England, as well as a newly established crisis management group. Since CME’s operations in Australia are currently limited, additional requirements under the regulatory influence framework have not been triggered. The Bank and ASIC nevertheless have a joint memorandum of understanding with the CFTC to support deference arrangements, both in respect of CME and in respect of the CFTC’s interest in ASX Clear (Futures). BIS central bankers’ speeches What remains to be done? Of course, the work is not yet done. While the reporting regime has been almost fully implemented and the transition to clearing is well advanced, some elements of the agreed international package of derivatives reform have yet to be completed. For instance, the international margining regime for non-centrally cleared derivatives is not due to come into force until next September; APRA is leading domestic work on the local implementation of that regime. At the same time, ASIC has been working on a framework for assessing the case for mandatory platform trading. This is one of the topics that will be considered in the regulators’ latest OTC derivatives market assessment report, due to published early next month. Internationally, work is continuing on CCP resilience, recovery and resolution. Regulatory arrangements supporting cross-border provision of CCP services will continue to be refined over time, with a particularly important area of focus being cross-border crisis management and resolution arrangements. The Australian regulators will continue to engage in these debates. Conclusion Let me draw all this together with a few concluding remarks. As I said at the outset, the work on derivatives reform is just one part of a wider effort to build resilience in our financial systems. Given the global nature of these markets, the regulatory work has necessarily had a strong international dimension. In engaging with this, the Australian regulators have sought to keep several objectives in mind. Of course, there is the overarching objective of financial stability. But there are a number of other important aims to be taken into account: supporting market functioning; the need for our institutions to maintain connectedness with the rest of the world; avoiding costly duplication or inconsistency of requirements with other jurisdictions; and ensuring that regulatory settings are proportionate to the risks that need to be managed. In balancing these aims, we recognise that it is important to consult thoroughly with market participants at each stage of the process. We take that very seriously. So I take the opportunity today to thank market participants, and to thank ISDA, for the constructive way that you’ve engaged with us on all these reforms. Thanks for your attention today. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 10 |
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at the CFA Institute Australia Investment Conference, Sydney, 13 October 2015. | Philip Lowe: Fundamentals and flexibility Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at the CFA Institute Australia Investment Conference, Sydney, 13 October 2015. * * * Accompanying charts can be found at the end of the speech. I would like to thank Adam Cagliarini for assistance in the preparation of these remarks. It is a pleasure for me to be able to speak at the CFA’s Australia Investment Conference. I participated in the 2013 conference in Melbourne and it is very good to be back at your 2015 conference here in Sydney. I would like to congratulate CFA Societies Australia for the topic that they have chosen for this year’s conference: Going Back to Fundamentals. In a world in which the focus is too often on the short term, this conference serves as a timely reminder that it is the fundamentals that really matter. In the area of finance, the CFA Institute has been playing a leading role in reinforcing the fundamentals of trust and fiduciary duty. Over recent years, we have seen too many examples around the world where not enough attention was paid to these fundamentals and, as a result, the reputation of the finance sector has been badly tarnished. The work of the CFA in promoting the highest standards of ethics and professional excellence is helping to return the focus on these fundamentals. This is important work and I wish you every success in it. This morning, though, I would like to focus on a different set of fundamentals: that is, the fundamentals of the Australian economy. My central message is that these fundamentals are strong and that they provide us with the basis to be optimistic about the future. At the same time, none of us has a crystal ball, so we can’t be sure exactly what that future holds. What we can be sure of is that we will be best placed to take advantage of our strong fundamentals if our economy is flexible and if it is able to adapt to the changing world in which we find ourselves. Hence the title of my remarks this morning: Fundamentals and Flexibility. Some background It is probably helpful to start with some context. This is usefully provided by this first graph, which shows various measures of how Australia’s output and real income have evolved over the past couple of decades or so (Graph 1). The green line shows output per hour worked. This is the conventional measure of labour productivity. The orange line shows real income per hour worked.1 In most countries, real output and income typically track one another quite closely and indeed this was the case for Australia during the 1990s. But over the 2000s, our real income increased much more quickly than our output owing to the large increase in our terms of trade. We became much better off as a nation because the prices of the goods that we were selling to the rest of the world increased quicker than the prices of the goods that we were buying from the rest of the world. The measure of income used here is Real Net National Disposable Income (RNNDI). It adjusts Gross Domestic Product (GDP) to take account of changes in the prices of our exports relative to our imports (the terms of trade effect), real income flows between Australia and the rest of the world, and depreciation of machinery, buildings and other produced capital. BIS central bankers’ speeches And, finally, the blue line shows real income, not per hour worked, but per person in Australia. This is probably the best measure of how average living standards have progressed through time: it takes into account the lift in productivity, changes in the relative prices of our exports and imports, and changes in the share of the population that is in paid employment. It is the strongest of the three lines shown here. This reflects the fact that over the past two decades or so there has been a substantial increase in the share of the population in paid employment; between 1993 and 2008, this share rose by 7 percentage points to over 50 per cent. This rise is accounted for by three trends: a decline in the unemployment rate, a rise in the participation rate and a decline in the share of children in the population (Graph 2). Taking these two decades or so as a whole, Australians have enjoyed very strong growth in average living standards. Real income per capita is currently around 60 per cent higher than it was in the early 1990s, having grown at an average rate of around 2 per cent per year over this long period. In the 1990s, we benefited from strong productivity growth. In the 2000s, we benefited from the rising terms of trade. And across both decades we benefited from increasing labour force participation and favourable demographic trends. The story, over recent years, is a less positive one. While productivity growth has picked up a bit, the terms of trade have declined, as has the share of the population in employment. As a result, there has been very little growth in real income per capita since 2008. As is evident from Graph 1, this is quite different from the strong upward trend over the previous 15 years. I suspect that it is this change that lies at the heart of some of the recent soul searching about the future of the Australian economy. This soul searching is evident in the increasing number of people asking what comes next. What comes after the resources boom? Where will future growth in our living standards come from? Where will the jobs of the future be? These are all excellent questions. They help focus our minds on the challenge ahead. And they can help promote better public policy. But we do need to be careful that the uncertainty that we feel about the future – and that is sometimes the undercurrent to these questions – does not mutate into chronic pessimism. If that were to happen, many of the opportunities that we do have are likely to go begging. Looking to the future, it is unlikely that growth in our living standards will again come from a sustained lift in our terms of trade, which remain high in a historical context despite the falls of recent times (Graph 3). Of course, we cannot dismiss the possibility that we will be lucky again. But it would surely be unwise to hope for ever-rising export prices as the basis for improving our living standards. Similarly, with our population ageing, it seems unlikely that we will see a repeat of the large increase in the share of the population in paid employment. Fundamentals This leaves improving our productivity – the bottom line in Graph 1 – as the only alternative. And this is where our fundamentals matter. I have spoken about some of these fundamentals on other occasions, but it is worth highlighting some of these again today.2 There are five in particular to which I would draw your attention. The first is our strong institutional framework, including: the rule of law, respect for property rights, a well-functioning public administration and a well-established regulatory system. We See Lowe P (2014), “Building on Strong Foundations”, Address to the Australian Business Economists Annual Dinner, Sydney, 25 November. BIS central bankers’ speeches can sometimes take these things for granted but, together, they form the bedrock upon which our high-income economy is built. The second is our people. Our education system ranks reasonably highly by global standards. Australians generally have a ‘can do’ mentality and we have a demonstrated capability to adjust to a changing world. We adopt new technologies relatively quickly and many of us are prepared to take a risk. And we have successfully drawn people from all around the world to our shores, with more than 40 per cent of our population having been born overseas or having at least one parent who was born overseas. The third is our tremendous base of mineral resources. Australia is fortunate to have some of the biggest and best-quality resource deposits on the planet. While the resources industry goes through large cycles, our resources continue to be in strong demand from the rest of the world. The export receipts from these resources effectively pay for many of the imports that we buy; over recent times these receipts have been equivalent to around half of Australia’s annual import bill. The fourth is our agricultural assets. As average incomes in Asia grow, so too does the demand for protein. Higher incomes also mean that there is a greater preparedness and ability to pay a premium price for high-quality, clean food. With our large tracts of agricultural land and the expertise built up from using that land over many decades, Australia has obvious advantages here. And the fifth is our links with Asia and our expertise in delivering high-quality services. Over recent years, the focus has been very much on our relationship with China. This focus is likely to continue. But there are also significant opportunities elsewhere, including in Indonesia and India with their very large populations. Many of these opportunities lie in the services part of the economy, including in tourism, finance, education and professional services. Together, this combination of fundamentals should provide us with confidence that we can continue to experience advances in our living standards. It is a combination of fundamentals that few other countries enjoy. The importance of flexibility In an ideal world, we might be able to take these fundamentals and map them into a clear path for the future. We might be able to say that these particular industries will thrive and these ones will not. That this is where the jobs of the future will come from. And that this is where we will find the success stories. Unfortunately, the real world is not so simple. It is full of surprises and it is difficult to predict. Looking back over recent decades, the two factors that stand out as the main sources of this unpredictability are advances in technology and shifts in the global economy. The advances in technology are reshaping, in unexpected ways, the jobs that we do. If we were to go back to 1995, or perhaps even to just 2005, I suspect that there are very few of us who could have imagined many of the new occupations that have emerged. There are big data architects, cloud computing experts, social media strategists, mobile app developers, information security technicians, green retrofit architects, genetic counsellors and the list goes on. Each of these new occupations is possible only because of advances in technology. More broadly, the huge growth in employment in the services sector has taken many by surprise (Graph 4). Again, I suspect that if in the early 1990s we had known that there would be a net loss of over 100 000 jobs in the manufacturing sector in Australia over the next 25 years, there would have been a sense of despair about the future. This despair would probably have been compounded if we had also known there would be no growth in jobs in both the utilities and wholesale trade sectors over the next quarter of a century. Yet, over this period, we have enjoyed a strong rise in our living standards, the unemployment rate has BIS central bankers’ speeches come down substantially and we have generated around 4 million new jobs across the economy, mostly in the services sector. As I said, the other big source of unpredictability has been shifts in the global economy. You might recall that around the time of the Sydney Olympics there was much gnashing of teeth by those who saw Australia as an old economy, just selling resources to the rest of the world at ever-declining prices. We were seen by many to be locked out of the ‘new economy’ and destined for decline. At the time, few people saw the great opportunities that would come our way as a result of the emergence of China as a major force in the global economy. One example of the difficulty of predicting change that I am fond of quoting comes from the conferences that the RBA organises every decade or so to provide a stocktake as to how our economy has evolved and the challenges ahead. In the volume published after the conference in 2000, the words ‘China’ and ‘Chinese’ do not appear a single time, but there were nearly one hundred references to the United States. In contrast, a decade later, in the volume published in 2011, there were nearly 300 references to China (with the number of references to the United States being similar to that in the 2000 volume). A related example of the changes that can take place due to the shifts in the global economy is from the changing destination of Australia’s exports. The very strong growth in the Japanese economy for some decades after World War II saw Japan become the major destination of our exports (Graph 5). Given this, if in the 1970s we had known what lay ahead for the Japanese economy, we might have been concerned about our own future. But as Japan slowed, exports to other parts of east Asia took off. And then, over recent years we have seen a third phase with the very strong growth of exports to China. None of these big shifts in our trade patterns was widely predicted. The point of these various examples is that, while we might wish for certainty about the future, it is not possible to have certainty. Technological progress is unpredictable and when it occurs it opens up possibilities that today we have trouble even imagining. And patterns in the global economy will no doubt continue to evolve. While we can hazard a guess about what this evolution might look like, the future does have a way of surprising us. So the question is how we can best take advantage of our strong fundamentals in this world where it is difficult to predict the future. A large part of the answer surely lies in ensuring that our economy has a high degree of flexibility. That it is adaptable and nimble. And that it can respond quickly to changes in relative prices and seize new opportunities brought about by advances in technology and shifts in the global economy. There is no single policy lever though called ‘flexibility’ or “adaptability”. The degree of flexibility of the economy is the result of the accumulation of numerous decisions and policies across many, many areas. In the area directly related to the central bank, the flexibility of the exchange rate is a key element. For more than three decades now our floating exchange rate has, arguably, been the single most stabilising influence on our economy. It has helped us deal with very large global shocks and it continues to do. In particular, the depreciation over the past couple of years is playing an important role in helping the economy adjust to the wind-down of the boom in mining investment. Another area critical to flexibility is the financial sector, as it provides the resources businesses need to expand as new opportunities emerge. While Australia has been well served by its financial institutions and markets over many years, we need to make sure the regulatory environment remains conducive to new forms of finance that can help fund innovation and the development of new ideas. The recent work by the Australian BIS central bankers’ speeches Government to facilitate crowd-sourced equity funding is a step in this direction.3 Here, the challenge is to get the balance right between funding innovation and protecting investors. Most of the areas, though, that affect the flexibility of the economy lie beyond the world of central banks and finance. I would like briefly to mention four of these. The first is the competitive environment in which firms operate. Where competition is robust and entry to markets is easy, businesses have a stronger incentive to find better ways of doing things. They also have a stronger incentive to move quickly, lest a competitor seize an opportunity before they do. I think it is fair to say that few businesses really like competition, but, often, it is competition that drives them to do better and respond to new opportunities. And competition benefits us all as consumers, bringing new and lower-cost goods and services to market. So, we need a regulatory environment that is conducive to new entry, including by those who are able to harness new technologies to reinvent how things are done. A second area is the nature of the incentives to innovate and to start new businesses. These incentives are affected by the tax system and the regulatory and legal systems. They are also affected by the general community attitude to risk taking. We will be better placed to take advantage of the opportunities made possible by our strong fundamentals if our culture is one that accepts risk and appropriately rewards risk taking. A third area is the operation of the labour market. From a macroeconomic point of view, Australia’s labour market arrangements have worked well over recent times. During the global downturn, flexibility in hours worked helped limit the rise in unemployment. Then, during the years of the resources boom, very large wage increases were mainly confined to the areas where skills were in the shortest supply and they did not spread across the economy as a whole. And more recently, the slowing in aggregate wage growth has helped employment to grow reasonably strongly despite below-average growth in the overall economy (Graph 6). So, from a cyclical perspective, the labour market has proved to be quite flexible and things have worked reasonably well. A more open question is the degree of flexibility in dealing with structural change. Again, we are more likely to be able to capitalise on our strong fundamentals if our system of workplace relations helps businesses and their employees respond quickly and effectively to new opportunities. This is especially so when business models and the preferred working patterns of Australians are changing. As the Productivity Commission’s recent draft report on Australia’s framework for workplace relations concludes, it should be possible to simplify and improve the responsiveness of our current system while, at the same time, addressing the sometimes unequal bargaining positions in the labour market.4 And the fourth area is the nature of our education system. No matter what the future holds, it seems probable that continual improvement in our human capital will hold us in good stead. But given the unpredictability of the world in which we live, we need to find the right balance between the development of specific technical and professional skills and the general cognitive skills that are central to flexibility and adaptability. In each of these four areas – competition policy, the reward for innovation, the industrial relations system and the education system – the choices that we make are critical to the flexibility of the economy. See, for example, Australian Government (2015), Facilitating Crowd-sourced Equity Funding and Reducing Compliance Costs for Small Businesses, Consultation Paper, The Treasury. Available at http://www.treasury.gov.au/~/media/Treasury/Consultations%20and%20Reviews/Consultations/2015/Crowdsourced%20equity%20funding/Key%20Documents/PDF/Crowd-sourced-equity-funding.ashx See Productivity Commission (2015), Workplace Relations Framework, Draft Report, Canberra. Available at http://www.pc.gov.au/inquiries/current/workplace-relations/draft/workplace-relations-draft.pdf BIS central bankers’ speeches I want to conclude by noting that I have not mentioned interest rates once today. That is not because they are unimportant! The RBA’s monetary policy plays a key role in dealing with cyclical swings in the economy. We aim to keep inflation low and stable so that people can go about their business without having to worry about large movements in the general level of prices. And our actions help promote stability in Australia’s overall economy and its financial system. These are all important contributions. But, ultimately, the rate at which our living standards improve is unlikely to be driven by the actions of the central bank. Instead, the improvement in our living standards rests on our ability to improve our fundamentals and enhance the flexibility of our economy so that it can take full advantage of the opportunities in our ever-changing world. I wish you all success today in your own deliberations about fundamentals and I would be happy to answer any questions. Thank you. BIS central bankers’ speeches Graph 1 BIS central bankers’ speeches Graph 2 BIS central bankers’ speeches Graph 3 BIS central bankers’ speeches Graph 4 BIS central bankers’ speeches Graph 5 BIS central bankers’ speeches Graph 6 BIS central bankers’ speeches | reserve bank of australia | 2,015 | 10 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the 2015 Economic and Social Outlook Conference, organized by The Melbourne Institute and The Australian, Melbourne, 5 November 2015. | Glenn Stevens: The path to prosperity Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the 2015 Economic and Social Outlook Conference, organized by The Melbourne Institute and The Australian, Melbourne, 5 November 2015. * * * I thank Emily Perry for assistance in compiling these remarks. Thank you for the opportunity to take part in this conference. The previous occasion on which I spoke at this event was six years ago (to the day, as it happens) in 2009. That conference carried the title “The Road to Recovery”. The background was that we had experienced a downturn in the economy at the end of 2008, at a time when the global economy went into a serious recession. For some months thereafter public discussion about the economy contained a good deal of fretting and debate over whether the word “recession” should be used to describe conditions in Australia. I certainly used the term myself. But by November 2009, it was pretty clear that the recession had been short and shallow, and that we were in fact already on the road to recovery. The issue then was managing the next phase – ensuring that the road to recovery joined the path to prosperity. At that stage, of course, what has been referred to as “mining boom mark II” still lay ahead. The terms of trade had fallen by close to 20 per cent from their 2008 peak, but had stabilised. They would rise by 40 per cent over the ensuing two years. Resources sector capital spending declined over 2009 but would more than double over the next several years, reaching the highest share of GDP for at least 150 years. These were much bigger increases than we expected at the time. An unusually long and strong search for yield in global capital markets, driven by ultra-easy monetary policy in the major jurisdictions, was just beginning. By and large this continues today, perhaps more so than we would all have hoped in 2009. The European crisis, which would challenge the very foundations of the European project, was, in late 2009, still to come. So there were some surprises in store over the ensuing six years. Nonetheless, some of the features of that next phase and the issues in managing it were reasonably apparent. It was clear that the remarkable growth of China was a powerful force and that Australia was becoming much more exposed to that growth – which was a good thing, but not without some risks. It was clear that there would need to be a focus on structural reform. It was clear that improving housing supply for a growing population and infrastructure for a growing economy generally would be a key theme. It was clear that there would need to be a significant effort at restoring the state of the budget, so that fiscal expansion would again be possible in the face of a future shock, as it was in 2008 and 2009. All these things were said at the time. 1 See Stevens G (2009) “The Road to Prosperity”, Address to the 2009 Economic and Social Outlook Conference Dinner (The Melbourne Institute and The Australian), Melbourne, 5 November. BIS central bankers’ speeches Where are we, then, six years on? The world economy, despite various threats, has not had a relapse into recession. Even with something of a slowing this year, global growth is still proceeding at a moderate pace. That said, this growth has taken extraordinary policy settings to achieve and many policymakers and observers find the outcomes disappointing. Most countries around the world would like some more growth. But they can’t all get it by just exporting to others and focusing their own demand inwards. And, for a variety of reasons, policymakers are finding the effectiveness of policies aimed at boosting domestic demand more limited than they might have hoped. In some cases the efforts that have been made to foster growth have not been without a degree of risk. For our part in Australia, we have managed the biggest terms of trade event for more than a century with, so far, some success. History has many examples of such booms that, ultimately, were not successfully managed and which ended badly. It’s easy to see how that happens. A gift of higher national income comes our way as a result of the discovery of natural resources or a rise in demand for them. The higher income permeates through the economy and before long even industries and regions not directly exposed to that shock are feeling good. Human nature being what it is, we tend to assume that the good times will continue and we borrow and spend accordingly. Credit growth speeds up, leverage increases, usually inflation increases. And then the terms of trade turn down, at which point the whole process goes into reverse – and a serious downturn ensues. The current episode is not yet over. But from what we can observe thus far, we can say two things. First, we did not see the same excesses on the upswing as we did in other similar episodes. 2 This has to put us in a better position to manage the inevitable down phase. Second, in the down phase we are still managing to grow. We are probably roughly halfway through the decline in resources sector capital spending now; the headwinds from that source are about as intense now as they are likely to get. We are still growing. It would be good if the growth was a bit stronger, but nonetheless over the past year the non-mining side of the economy has generated respectable growth in employment. The ‘rebalancing’ is occurring. It isn’t as seamless as it would be in an ideal world, but we don’t live in such a world. Monetary policy is contributing to that rebalancing, consistent with its mandate, with a very accommodative stance. It seems likely that an accommodative stance will be appropriate for some time yet. Were a change to monetary policy to be required in the near term, it would almost certainly be an easing, not a tightening. The rate of CPI inflation is clearly no impediment to easing. The housing market may be calming, lessening risks from that source, though by how much and how persistently we cannot yet know. This is perhaps an opportune moment to offer some observations about the recent change in mortgage interest rates on the part of the major, and some smaller, banks and in particular the question of whether the Reserve Bank should respond to it with a decline in the cash rate. On some other occasions, the Reserve Bank has moved the cash rate by more than otherwise to take account of changes in the relationship between the cash rate and other interest rates. One such occasion was in May 2012, when the Reserve Bank Board wished to ensure that the economy received a worthwhile stimulus from a policy easing after a period in which lending rates had tended to increase even while the cash rate had been steady. The Board wanted to make sure that financial conditions would move to a clearly easier position than they had been when the cash rate had previously been lowered, five Indeed, Rees and Kulish (2015 RDP) suggest that households behaved as if much of the shock was temporary. BIS central bankers’ speeches months earlier. So on that occasion the Board decided on a larger than normal reduction in the cash rate. The question that is relevant for the Reserve Bank Board at present is, first and foremost, whether the recent changes in mortgage rates result in an effective set of financial conditions that is “too tight” for the economy. In addressing that question, it’s worth noting that over the course of 2014 and 2015, effective rates on most loans tended to decline by more than the cash rate, reflecting both declining funding costs and increased competition to lend. For fixed rate mortgages and many business loan rates the fall was quite marked. The average rate on outstanding business loans, for example, fell by over 90 basis points during a period in which the cash rate fell by 50 basis points. Even for floating rate mortgages, rates had fallen a bit more than the cash rate. The actions of those banks that have lifted mortgage rates over recent weeks reverse a little under half of this year’s decline for floating rate mortgages for owner-occupiers and have no effect, at this stage, on the 15 per cent of loans with fixed rates. For investors in housing, these actions and those a month or two earlier reverse the effects of this year’s monetary policy easing but, of course, this was the lending that had been growing most quickly. Business loan rates have not risen. Measuring across the total loan book, the recent actions are the equivalent of roughly half of one 25 basis point monetary policy change. They take back perhaps a quarter of the extent of interest rate easing seen since the start of this year, and a smaller proportion of the total easing in lending costs seen over the past two years. For mortgages, this increase is from the lowest rates that any current borrower will have ever seen. As it is, there are still a number of mortgage products with rates not much above 4 per cent, even a few advertising a “3” before the decimal point. We also note that a significant proportion of owner occupier households is ahead of schedule on mortgage repayments – in large part because these households did not lower their payments as interest rates fell. Most of these households are unlikely to need to part with extra cash each month as a result of the recent interest rate changes. (Equally, many of these households were probably not boosting spending as interest rates fell, instead allowing their loan principal to fall faster.) As for the general environment, according to business surveys conditions outside mining have been slowly improving, not deteriorating. So it is not as though the increases in mortgage rates are compounding the effects of a serious deterioration in economic conditions overall. Could the “shock” value of the rises in mortgage rates itself lead to a significant change in that trend, gentle as it is, of improvement? While such an outcome is perhaps conceivable, given the starting point and all the above considerations, it seems to me a bit of a leap to draw that conclusion. At this point, then, my preliminary assessment is that the macroeconomic effect of these actions in themselves may not be large. It is one part of a much bigger and evolving landscape. Nonetheless, the Reserve Bank Board will keep this matter, and that broader landscape, under careful review. Let me be clear that in making these comments I am not offering an endorsement of the banks’ actions. Nor should an assumption that shareholder returns must not decline as a result of the effects of supervisory measures, or any other factor, simply be accepted without question. The “right” rate of return for bank shareholders is, as others have observed, an open question. It is not a constant of the universe. BIS central bankers’ speeches Returning then to the general theme of “where are we, six years on?”, my next observation is that many of the points that were being made at that time remain as relevant today as they were then. The Australian economy’s exposure to China has increased, as was understood then. So China’s prospects matter more. The current rate of growth of the Chinese economy is uncertain, as is its future growth rate. Chinese policymakers are attempting a profound transition in the growth model while dealing with some legacy issues (such as a substantial debt build-up) arising from the previous model. It is likely that the marginal steel intensity of China’s growth will be lower in future than in the past. Some suggest that Chinese steel consumption, which has fallen this year, may continue to do so. At the same time, the marginal propensity of the Chinese people to consume services is rising noticeably. So the challenge for Australian resource producers to be the most efficient suppliers in a world of slower growth in demand for resources will co-exist with greater opportunities for other firms to offer value added in services. The challenges of adjusting the responsiveness of our economy and developing its infrastructure, noted six years ago, are still relevant. To say this is not at all a suggestion that nothing has been done in the interim, but the importance of productivity performance for growth in living standards has become progressively clearer as the terms of trade have fallen. The effects of population ageing, moreover, while slow moving, are now occurring. There is perhaps more of an edge in the productivity discussion just lately, as there should be. On infrastructure, there are some encouraging developments and a degree of expectation is building. Without wanting to dampen the enthusiasm in any way, I simply repeat that the key issue is not funding. The key issues are: governance, appropriate risk sharing and pricing. The need for medium-term budget repair also remains. Here also progress has been made, and the budget deficit at present still compares favourably with what we see in many other countries. But my sense is that a fair bit of the necessary national conversation about how we pay for all the things we have voted for lies ahead. This doesn’t imply a need for radical immediate action, but I suspect it does mean an unusually long period of tight budget discipline on recurrent spending is likely to be required. Perhaps the main message is that the nature of the path to prosperity doesn’t seem much different today from what it was six years ago. Macroeconomic policies can provide a measure of counter-cyclical stabilisation, but they can’t serve as a magic bullet to achieve sustained growth in living standards. And with the terms of trade-driven improvements now behind us – and at least partly reversing – productivity is the main game. Gains in productivity come in part from improvements to the way we do the things we currently do, in part from stopping doing things we are not very good at and doing more of things we are good at. It’s understandable that this is often seen as a threatening notion and it is certainly disruptive when adjustment has to happen in a short period. It is unrealistic, though, to think the pressure to adjust will simply go away. But equally importantly, gains will come from doing completely new things – the provision of new products to meet people’s changing desires and needs. These will also, in time, be sources of major employment opportunities. The answer to the question “where will the jobs come from?” is usually: from lots of places we haven’t thought of yet. Many of the jobs in the economy today are in activities that few predicted 25 years ago. Few would have foreseen the vast growth in employment in a range of industries that provide services to both households and businesses. For example, employment associated with computer system design and related services has quadrupled as a share of total employment over the past 25 years. Few would have anticipated the rapid rise in employment related to social media, cloud computing and the creation of apps or other services related to environmental sustainability, to take just a few examples. It will also surely be the case in the BIS central bankers’ speeches future that jobs will come from unexpected places and new occupations will continue to emerge. The questions then are whether Australian businesses and their workforces have, or can acquire, the necessary capabilities to offer those services and perform those jobs; whether the incentives they face to do so are adequate; whether the public policy framework appropriately encourages risk-taking and entrepreneurship; and so on. No doubt various aspects of “reform” are needed to ensure the answers to such questions are in the affirmative. As on other occasions when “reform” has been discussed of late, my suggestion would be that such reforms are most likely to succeed – that is, to be implemented in a durable fashion – when the conversation is framed within a narrative about growth. Hopefully your deliberations today will contribute to that narrative. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 11 |
Remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at FINSIA Regulators Panel, Sydney, 5 November 2015. | Philip Lowe: The Reserve Bank of Australia’s regulatory responsibilities Remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at FINSIA Regulators Panel, Sydney, 5 November 2015. * * * I would like to thank Stephanie Bolt, Jon Cheshire and Matt Gibson for assistance in the preparation of these remarks. I would like to thank FINSIA for the invitation to speak today. It is a pleasure to be part of this year’s Regulators Panel. The Reserve Bank’s regulatory responsibilities lie in three general areas. First, along with APRA, we have a broad responsibility for stability of the financial system. Second, we have specific responsibilities for competition and efficiency in Australia’s payments system. And, third, we have responsibility for prudential supervision of Australia’s clearing and settlement facilities. This afternoon, I would like to say a few words about each of these three areas and some of the issues that lie ahead. Financial stability – the importance of good quality data First, the financial stability responsibility. Over recent times, much has been said about the risks in the Australian housing market, with the Reserve Bank publishing its latest analysis just a few weeks ago in the six-monthly Financial Stability Review. Rather than go over this ground again, I want to highlight just one issue: that is, the importance of high-quality data. Now this might seem a rather obscure issue to highlight. But the basis of good analysis is good data. Improvements over time in the quality and comprehensiveness of the data on housing prices have, for example, helped improve the general understanding of housing market developments. In contrast, unfortunately, recent problems with the data relating to banks’ owner-occupier and investor housing loans have worked in the other direction, complicating our understanding of what is going on in the housing market. These data problems have emerged as lenders have taken a closer look at their housing loans following increased supervisory scrutiny. As lenders have looked more closely, what they have found has surprised and, to some extent, concerned us. There are two issues that are worth drawing your attention to. The first is that over the past six months there have been very large upward revisions to the value of investor loans outstanding, with offsetting downward revisions to owner-occupier loans. Material revisions have been made by more than 10 institutions, including two of the largest lenders. The scale of these revisions can be seen in Graph 1, which shows the stock of investor credit outstanding as reported in each of May, June and September this year. The cumulative effect of the upward revisions has been to increase the stock of investor credit outstanding by around $50 billion, or 10 per cent. According to these new data, investor loans now account for 40 per cent of total housing loans outstanding, not the 35 per cent reported earlier in the year. BIS central bankers’ speeches Graph 1 Click to view larger While the reasons for some of these earlier errors have been identified, in other cases the reasons are unclear and lenders have not been able to provide comprehensive back data. As a result, when calculating growth rates for investor and owner-occupier credit, the RBA has had to make adjustments for what are effectively breaks in the series. The second data issue has emerged over the past couple of months and has worked in the other direction, with lenders reporting that some loans that were previously recorded as investor loans were really loans to owner-occupiers. This is partly because, when faced with the higher interest rate on investor loans, some borrowers have indicated to their bank that they are not an investor, but rather an owner-occupier, and so should not have to pay the higher rate. Our liaison with lenders suggests that further reclassifications of this nature could be expected over coming months. The effect of these recent reclassifications on measured growth rates can be seen in Graph 2. Taken at face value, the data suggest a very sharp slowing in growth in investor credit and a sharp pick-up in owner-occupier credit (shown as the dotted lines). However, if we make adjustments for these reclassifications then the changes in growth rates are much less pronounced (the solid lines). Graph 2 Click to view larger BIS central bankers’ speeches These various data problems have reinforced our view that the supervisory focus on investor lending has been entirely appropriate. And it is disappointing that some lenders’ internal systems have not been up to the task of reporting accurate data on the split between investor and owner-occupied housing loans. This issue was discussed at the most recent meeting of the Council of Financial Regulators, with Council members considering what steps could be taken to improve the quality of data. Among other things, it has been decided that APRA, the RBA and the Australian Bureau of Statistics will, next year, undertake a thorough review of the data collected from authorised deposit-taking institutions regarding their domestic books. Payments system issues The second area that I would like to touch on is the RBA’s payments system work. Here, there are two issues of particular focus over the year ahead. The first is the industry efforts to develop a new 21st century payments system for Australia. These efforts are, to a significant degree, in response to the RBA’s strategic review of innovation in the payments system that was concluded in 2012. While some aspects of Australia’s payments system rank relatively well by global standards, the underlying architecture for some of our systems has aged and is limiting innovation. One example of this that many of you may be familiar with is that when you send a payment from your online bank account to another person or business you are limited to just 18 characters in describing the payment. The reason for this restriction is that the entire payment instruction – including the BSB, the amount, the banks involved etc. – is limited to just 120 characters. And the origin of this limit is the capacity of the magnetic tapes that were used to exchange information between banks and, before that, the capacity of computer punch cards with their 80 columns. In effect, our payments system in 2015 is still being constrained by the technology of earlier generations. So it is difficult to argue that this renewal of our payments system is before time! The new system will allow Australians to transfer money to one another almost instantly, no matter where they bank. It will also remove the need to know somebody’s BSB to make a payment; just a phone number or email address will be needed. And we will no longer be limited to just 18 characters in describing the payment; instead we will be able to send a wealth of information. The industry is working hard on building this new system. It is a very significant piece of work, involving many hundreds of millions of dollars, and the timeline is relatively tight. But when finished, it is likely to form the backbone of many of our payment systems over the next few decades. The RBA is closely involved in all of this work. It has played a major role in establishing the broad direction of the industry’s efforts. It is building a core piece of infrastructure that will allow payments to be settled in real time. And it is also building the capability for our own customers – primarily the Australian Government – to use this new payment system. The second area of focus over the next year is the ongoing review of the regulation of the card payments system. Earlier in 2015, the RBA released an issues paper inviting submissions on a broad range of topics in this area. A number of these were also discussed in the Financial System Inquiry (FSI). The topic that has attracted most attention is the concerns about excess surcharging on credit cards. In its response to the FSI, the government indicated that it will ban excessive surcharging and give the ACCC enforcement powers. An important element here is to define what exactly constitutes ‘excessive surcharging’. This is an issue the RBA will be working on over the months ahead. We will also be working closely with Treasury and with the ACCC as the necessary legislation is developed. BIS central bankers’ speeches Another relevant topic is the appropriate level of the interchange benchmarks in the card systems and the compliance arrangements around those benchmarks. We are continuing to consult on whether it is in the public interest for these benchmarks to be lowered. In terms of compliance, perhaps not surprisingly, the schemes have become increasingly adroit at maximising interchange fees while still complying with the benchmarks. We have seen interchange pricing become increasingly complex, with significant price discrimination between merchants. We have also seen the schemes introduce and promote new high-interchange, high-reward cards, with merchants typically having little, or no, visibility over the interchange fees that apply when a specific card is presented. How best to deal with these developments – including whether the compliance arrangements can be simplified and whether transparency of the system can be further improved – is an important ongoing element of our work. Clearing and settlement facilities The third area of our regulatory responsibilities that I want to touch on is the one area where the RBA still effectively acts as a prudential supervisor; that is for central counterparties and securities settlement facilities – two types of so-called financial market infrastructures (FMIs). Since the financial crisis, the prudential regulation of these entities has taken on added focus, both in Australia and elsewhere. This reflects the critical role that these entities play in the smooth functioning of the financial system, with this role increasing following the agreement by the G20 nations to clear all standardised OTC derivative through central counterparties. While, globally, the transition to central counterparties has been slower than was originally agreed, significant progress has been made. In Australia, the majority of new trades in standardised interest-rate derivatives is now centrally cleared. This shift has been supported by recently introduced regulations that provide for mandated central clearing of interest-rate derivatives denominated in Australian dollars and other major currencies for internationally active dealers. 1 Over the next year or so, the RBA’s priorities for work in this area will include two key elements. The first is the development of more robust crisis management arrangements for FMIs. The RBA currently sets standards that the FMIs it supervises are required to meet. These standards provide a high degree of assurance regarding the stability of these entities, but they don’t rule out the possibility that they could experience severe financial difficulties, prejudicing the stability of the overall financial system. Given this, it is important that there are appropriate arrangements in place to deal with such an eventuality, should it ever arise. The current arrangements in this area were considered by the FSI and have been under review by the Council of Financial Regulators for some time. In its response to the Inquiry, the Government endorsed the implementation of a framework to provide regulators with clear powers in the event that an FMI was heading towards failure. This is consistent with an existing proposal consulted on by the Government to make the RBA the resolution authority for central counterparties and securities settlement facilities based in Australia. Under the proposed arrangements, the RBA would be able to give formal directions and to intervene if severe financial stress of an FMI risked causing wide disruption to the financial system. One way that the RBA might do this is to appoint a statutory manager to operate the critical functions of the FMI for a period of time. This is similar to the framework that is already in place for banks and that is the responsibility of APRA. For a more detailed update on the progress of reforms, <http://www.rba.gov.au/speeches/2015/sp-ag-2015–10–22.html>. see Edey (2015), available at BIS central bankers’ speeches Developing these arrangements for FMIs is a significant task. Changes in legislation are required and the RBA is developing detailed strategies and operational arrangements. These efforts are drawing on international work on resolution strategies led by the Financial Stability Board, as well as similar work that has been undertaken for banks. The second, and related, priority relates to the growing threat to FMIs from cyber attacks. By their very nature, these entities are heavily dependent on technology and connections to external parties, and this dependency has increased over recent years. At the same time, the nature of cyber threats has rapidly evolved, with increasingly sophisticated methods being used by those attempting to cause disruptions. The RBA is working closely with the FMIs it supervises to better understand their approach to cyber resilience. As part of this work, the RBA and ASIC asked the ASX to conduct a selfassessment of its cyber-security practices for the FMIs that it operates. This assessment concluded that the ASX’s practices were generally aligned with the upper tiers of maturity levels under internationally used cyber security standards. 2 But this is an area that needs to be continually watched, and there is considerable work going at the international level, with the RBA closely involved in this work. As a financial institution itself, the RBA also sees the increasing prevalence and sophistication of cyber attacks and has made its own very significant investments to address the risks. In the area of payment infrastructure, we are undertaking work to strengthen further the resilience of the Reserve Bank Information and Transfer System, commonly known as RITS. This system is owned and operated by the RBA and lies at the heart of Australia’s wholesale payment system. With those introductory remarks I look forward to participating in the panel discussion. Thank you. ASX’s high-level self-assessment was carried out against the United States National Institute of Standards and Technology Cybersecurity Framework. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 11 |
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Australian Property Institute's Queensland Property Conference, Gold Coast, 6 November 2015. | Malcolm Edey: The risk environment and the property sector Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Australian Property Institute’s Queensland Property Conference, Gold Coast, 6 November 2015. * * * Thanks for the opportunity to speak to you today. This being a conference of the property industry, I expect you will want to hear me say something about the Australian property market. I will come to that a bit later in the speech. First, though, I want to provide some context for that by talking about the financial and economic environment more broadly. In doing so, I will be making some longer run observations as well as drawing on the analysis recently published by the Reserve Bank in our half-yearly Financial Stability Review. The post crisis environment I want to begin by noting that the process of recovery from the global financial crisis (GFC) has been underway for some years. The epicentre of the crisis is usually dated to the collapse of Lehman Brothers in September 2008, and the general recovery that we have had since then began about six months later. On that basis, we have been in a period of aggregate global recovery now for about 6½ years. In broad outline, this has been a period marked by: • a return to approximately trend growth in world GDP, though with some variations around that; (Growth is currently a bit less than trend.) • widespread, though somewhat variable, progress in balance sheet repair in banking institutions; and • improved conditions in financial markets. These are all positive developments, and they represent a substantial cumulative improvement since the height of the crisis. That said, there are a number of qualifications that should be made to the summary picture I have just given: • Growth around the world during this period has been uneven geographically. China and other emerging market economies have led the recovery for much of the period, the US has achieved fairly steady growth, while Europe tended to lag. (More recently Asian growth has softened while Europe has picked up somewhat.) • Significant labour market slack remains in some areas of the global economy, especially in parts of Europe. • And the recovery has been marked by periodic bouts of nervousness in financial markets. One general indicator that things are still some way short of normal is the level of global interest rates, which are still at exceptionally low levels to support growth. An obvious question that arises from all of this is, why has the recovery from the deep recession of 2008 and 2009 been as protracted as it has? I suggest that there are two important factors at work here. The first factor is that the GFC period involved more than one crisis. It began in the US mortgage market in 2007 and spread through various channels of contagion to banks and BIS central bankers’ speeches financial institutions in other parts of the world, especially the euro area and the UK. That was the initial crisis, triggered by poor asset quality and excessive leverage. But even as the US was recovering from that, a second crisis was developing in Europe. This was a crisis of confidence in the sustainability of the euro as a single currency area. At different times a number of the weaker economies in the area came under scrutiny as to whether they would be able to meet their obligations, and concerns were particularly focused on Greece in key periods. These episodes led to strains in financial markets and increases in risk pricing, and they weighed heavily on confidence and on the pace of recovery. With the euro area accounting for around one fifth of the global economy, this in turn acted as a significant drag on global growth. The second factor is that, other things equal, recoveries from financial crises typically take longer than those from other types of business cycle events. It takes time to repair balance sheets, to reduce excessive leverage and to unwind the asset market imbalances that might be left behind by a crisis; and it takes time to reverse the damage to trust and confidence. One important recent study 1 found that the average duration of impact from financial crises across a range of countries over the past two centuries has been around four to five years. Since this current episode has been more severe than most, it is not surprising that its aftereffects have lasted even longer. An exacerbating factor, too, has been the international dimension. When a financial or a banking crisis occurs in a single economy, or in a smallish group of countries, exchange rate depreciation is often part of the market response and part of the recovery mechanism. But there is obviously much less scope for that mechanism to work when a crisis affects large parts of the global economy simultaneously. Taken together I think these factors go a long way towards explaining the rather drawn-out nature of the global recovery to date – even though, as I said, conditions now are much better than they were a few years ago. Policymakers around the world have been responding to this situation on a number of fronts. Interest rates were reduced to near zero (or even slightly below zero) in many advanced economies to support recovery and assist in balance sheet repair, and they still remain at those levels. In Europe, significant institutional reforms are being made to strengthen the stability of the euro area; these are aimed at getting banking and crisis-management arrangements across the area to function in a more unified way that makes them more robust to shocks in the future. And globally, there is an extensive program of reform underway, for example in banking and securities regulation, to build resilience in our financial systems. Australia has been very much a part of that process. A related development in this period is that there has been a renewed interest in more proactive approaches to the management of systemic risk. Partly this reflected the lesson from the GFC itself that financial crises are costly, and hence that there is a strong need for better risk management. In keeping with that, institutional arrangements have been strengthened in some jurisdictions to support more proactive risk management by supervisors, where that was found to be lacking. A related point is that, in a low interest rate environment, supervisors have seen a need to be particularly vigilant against a build-up of risk in interest sensitive sectors. A number of them have been taking measures in recent times to respond to developing risks, often focused on property lending. I will have more to say about that later. To summarise (and oversimplify) this picture somewhat, the after-effects of the GFC on the global economy have included: Reinhart CM and K Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, Princeton. BIS central bankers’ speeches • an extended period of low interest rates • “search for yield” behaviour by investors in some interest-sensitive sectors, and • a strengthened focus on risk management by prudential supervisors. Recent developments With all of that as background, I want to turn now to our assessment of the evolving risk environment over the past six months, and here I draw on some key messages from our recent Review. It is useful to take that subject in three parts: • the global risk environment; • possible implications of that environment for Australia; and • domestically generated sources of risk. The global risk environment As I have already mentioned, much of the attention from a financial stability point of view over recent years has been on Europe. There has been a particular focus on Greece, and on potential spillovers from Greece to other parts of the euro area. Those concerns came to a head around the middle of this year. For the time being at least, they seem to have been allayed by the new bailout package agreed at that time. Unlike the earlier phase of the Greek crisis in 2011 and 2012, market spillovers from this latest bout of uncertainty have been quite limited; for example, risk spreads on securities across other parts of Europe remained relatively low. This seems at least partly to reflect a greater degree of confidence in Europewide institutions. The European authorities have taken a number of actions to reduce channels of contagion, including increased support from the ECB and ongoing progress in unifying the system of banking regulation. More generally in Europe, the condition of the financial sector has been improving over the recent period in a number of respects. Non-performing loans of European banks are still high, but they have been falling for more than a year (Graph 1). Bank profitability has picked up and banks are now better capitalised. Stronger balance sheets have enabled banks in the euro area to make some gradual increases in their lending to businesses and households. Overall, while financial conditions in Europe are still some way from a return to normal, they are significantly improved from their position of a few years ago. BIS central bankers’ speeches Graph 1 Click to view larger While financial risks in Europe seem to have lessened recently, attention has shifted to China and other emerging market economies. China has been an important engine of growth in the post-crisis period. Nonetheless, our latest Review notes that financial stability risks in China have been building. The Chinese economic expansion over recent years has been associated with increasing debt, strong asset price growth and apparent overinvestment in some sectors (Graph 2). If the nominal growth rate were to fall further from its high recent rates, any past excesses might be exposed – leverage is always harder to manage in a slower growth environment. These risks of course are hard to assess. The Chinese authorities have many levers to support growth and financial stability, given the ongoing large role of the state in the economy, the heavily regulated financial system and the presence of capital account controls. The measured central government fiscal position is also very strong, though the overall public sector position is less so given the build-up in debt among local governments and state-owned enterprises. BIS central bankers’ speeches Graph 2 Click to view larger Outside China, country-specific risks seem to have increased in a number of other emerging market economies – for example Brazil, Russia and Turkey. Among the various factors contributing to that in recent times have been falling commodity prices, political instability and excessive corporate leverage. Equity prices and exchange rates in these economies have fallen quite sharply. Taken together these developments have contributed to a pick-up in volatility in global financial markets over the past six months, after a lengthy period when volatility and risk pricing were unusually low. Even so, risk pricing in most markets remains well below the crisis-related peaks of a few years ago. Implications of the global risk environment for Australia At this point it is useful to ask how these international sources of risk might affect the Australian financial system. Direct exposures of Australian banking institutions to the risk factors I have been describing are quite limited (Table 1). Exposures to the euro area have been scaled back in the wake of the crisis and now represent only around 1 per cent of Australian banks’ consolidated global assets. Although exposures to the Asian region have been growing quite rapidly over recent years, they are still a relatively small share of consolidated assets – around 5 per cent. Many of these exposures are shorter-term and trade-related, factors which should lessen credit and funding risks. That said, operational and legal risks could be relatively high, particularly given the rapid expansion of these activities in recent times. BIS central bankers’ speeches Table 1 Australian-owned Banks’ International Exposures Ultimate risk basis, June 2015 Value Share of international Share of global exposures consolidated assets $ billion Per cent Per cent New Zealand Asia(a) – China United Kingdom 176 United States Europe – Greece Other Total (a) Asia includes offshore centres Hong Kong and Singapore. Sources: APRA; RBA. As a more general observation, Australian banks have increased their resilience over recent years in a number of respects, responding both to market expectations and to regulatory and supervisory actions. Notably they have raised their capital ratios and shifted their funding structures to make them more resilient to financial market disruptions. Of course, none of this guarantees that Australian banks will be immune to international shocks in the future. But it suggests that the main effects from the risks I’ve been describing are likely to be indirect, working through the impact of factors like commodity prices, trade flows, and confidence, on the broader economy. Domestically generated sources of risk That brings me to the third part of our risk assessment, namely domestically generated sources of risk. Here our analysis has for some time focused on the buoyancy in parts of the property market and the leverage associated with that. Much of the focus has been on residential property, and I will start with that before turning to the commercial sector, where risks have also been growing. While the housing market has not been universally strong around the country, we have been seeing significant strength in the Sydney and Melbourne markets in recent times, with investors playing a large role. To summarise a few key facts: • Housing prices in Sydney have increased by 31 per cent over the past two years, and reached an annual rate of increase of almost 20 per cent earlier this year. • Melbourne prices were up by 16 per cent over the year to September this year. • The value of loan approvals to investors in New South Wales approximately doubled over the two years to mid-2015. BIS central bankers’ speeches As a result of these developments, the household debt ratio has started to edge up again from a level that was already high, at around 1½ times annual income (Graph 3). Graph 3 Click to view larger It is against this background that the Reserve Bank has highlighted the need for prudence, and has supported APRA and ASIC in the measures that they have taken to strengthen lending standards. As a general proposition, mortgage lending standards in the post-crisis period have been relatively tight, at least more so than before the crisis. Low-doc loans are rare, genuine savings are required to fund at least part of the deposit, and the application of interest rate buffers in serviceability assessments has become common. Nonetheless, investigations by APRA and ASIC have shown that there was some slipping in lending standards and that they were inadequate in some important respects to the current risk environment. Specifically, APRA found that, in some instances, lenders’ serviceability assessments were based on over-optimistic judgments about the reliability of borrowers’ incomes, or inadequate estimates of borrowers’ living expenses, or that they failed to take into account the possible effect of future interest rate movements on a borrower’s existing commitments. ASIC’s review of interest-only lending practices made similar findings, and also noted instances where the lender did not make reasonable inquiries as to whether the loan product was suitable to the borrowers’ circumstances. Further to those findings, as a result of the additional scrutiny over the past year and substantial data revisions made by the banks, we now know that the level of investor activity in the housing market was in fact higher than previously thought. As you know, APRA announced a number of supervisory measures in December last year to strengthen mortgage lending standards. These measures included expectations that: • banks should not be increasing their share of higher risk lending • growth in investor lending should not be materially above 10 per cent BIS central bankers’ speeches • appropriate interest rate floors and buffers should be applied in serviceability assessments. It will take time for the full impact of these measures, and of the more recently announced increases in bank lending rates, to become apparent. Nonetheless, the indications to date are that the supervisory measures are having a beneficial effect on lending standards and are assisting in restraining new investor finance. There is also some tentative evidence that sentiment may now be turning in the housing markets in the two largest cities. But it is much too early to be definitive about that. What we can say is that the risks in that sector are now being more prudently managed than they were a year or so ago. The second main area of risk focus domestically is in commercial property. Historically this has been a common source of financial instability both here and abroad. During the height of the GFC, Australian banks remained in comparatively good shape but they did suffer a noticeable deterioration in asset performance, with the aggregate non-performance rate rising to just under 2 per cent of loans. A significant part of that deterioration was in commercial property lending; impaired commercial property exposures accounted for around 30 per cent of Australian banks’ non-performing domestic assets at that time. After the post-crisis downturn, the commercial property sector is again experiencing strong investor demand, and bank lending to the sector is increasing. However there are a number of signs of increasing risk. Trends in commercial property prices and rents have been diverging over the past few years, with prices continuing to rise while rents have been flat to down (Graph 4). As a result, yields have declined. At the same time, vacancy rates have been increasing. Graph 4 Click to view larger As in the housing market, conditions have not been uniform across the country, and they have been noticeably firmer in Sydney and Melbourne than in other centres. But in aggregate, the major categories of commercial property have all seen downward pressure on yields over recent years. Strong demand from foreign buyers has contributed to this, reflecting the global environment of low interest rates and “search for yield” (Graph 5). The BIS central bankers’ speeches risks appear manageable at this stage, but they underscore the need for sound lending practices and for appropriate prudence by investors. Graph 5 Click to view larger Concluding comments I want to conclude with a few comments about the financial stability role of the Reserve Bank 2. The Bank has a longstanding mandate for financial stability, affirmed for example as part of the Wallis reforms in 1998. In the post-Wallis world, this has not been primarily a regulatory function. The Bank does have regulatory powers in some areas relating to financial stability, notably in its oversight of payments systems and financial market infrastructures. But the financial stability function goes well beyond that to the Reserve Bank’s wider role in the financial system. It includes the Bank’s role as liquidity manager for the system and as the provider and operator of core payments infrastructure. It also includes coordination with other regulators. At a formal level, this is done through the Bank’s role in chairing the Council of Financial Regulators, but there are numerous less formal channels for coordination and for sharing information and analysis. These arrangements were reviewed and supported most recently in the Murray Inquiry. One important component of our financial stability work is the provision of timely risk analysis, to help inform the policy debate and also to help inform the decisions of lenders and investors. I have given a summary of our most recent analysis today, and I hope you will find that helpful in informing your own investment decisions. With that, I thank you for your attention, and hope you have a successful conference. For a fuller discussion of this topic, see my earlier speech “The Financial Stability Role of Central Banks” May 2013. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 11 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Bloomberg Summit, Sydney, 18 November 2015. | Guy Debelle: Benchmarks Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Bloomberg Summit, Sydney, 18 November 2015. * * * Thanks to Ellis Connolly and Matt Boge, both for their help in putting this speech together, but also for their significant contributions to the domestic and global work on benchmark reforms. Today I am going to talk about benchmark rates, in both fixed income and foreign exchange. This is an issue that might seem arcane to some, but like Jonathan Richman, “I keep my place in the arcane”. Benchmarks are very much at the heart of the plumbing of the financial system. Indeed, every investor with any global or fixed income exposure is almost certainly investing in a product that uses a benchmark rate, even if they don’t know it. After having been taken for granted for many years, benchmark rates have well and truly come into the public domain in recent years with headline-generating legal cases and multi-billion dollar fines. They have also attracted considerable regulatory scrutiny and reform to redress some of their deficiencies which made them vulnerable to abuse. Participating in this global reform of benchmark rates has been my night job for the past couple of years and it is these reforms that I wish to talk about today. As participants in financial markets, it is important that you have some understanding about what these reforms are endeavouring to achieve. I will talk first about benchmark reform in foreign exchange and also mention briefly the work on developing a single code of conduct for the foreign exchange market. Then I will talk about interest rate benchmarks, focussing on domestic reforms around the principal interest rate benchmark in Australia, the bank bill swap rate, consideration of a “risk-free” interest rate for the domestic market and briefly some (small) changes to the calculation of the cash rate, the Reserve Bank’s operational target for monetary policy. FX Benchmarks I will start with foreign exchange (FX) benchmarks. Why should you care about these benchmarks? For starters you might have a contract which explicitly references a particular FX benchmark. But probably more likely, if you invest in any sort of global portfolio, be it in fixed income or equity, it is highly likely that the portfolio uses an FX benchmark to weight the components across different markets, generally the London 4pm set of foreign exchange benchmarks calculated by the WM Company. Moreover, as the portfolio is rebalanced periodically (often at month end) to reflect movements in prices over the period, it is very likely that the foreign exchange transactions to rebalance the FX component of the portfolio occur during the London 4pm fixing window to minimise the tracking error against the calculated benchmark. So while you might think you are investing in equities or fixed income in your global portfolio, you are also passively investing in foreign exchange. From early 2013, concerns were increasingly raised about the integrity of FX benchmarks, particularly around the potential for market misconduct in the trading around the time of benchmark fixings. Accordingly, the Financial Stability Board (FSB) formed a group chaired by Paul Fisher of the Bank of England and me to firstly analyse the structure of the FX market and the incentives that might promote inappropriate trading activity around a fix, and then come up with some potential remedies to address the problems we found. After talking to participants from all sides of the FX market around the world, in September 2014, we proposed 15 recommendations to reform the FX benchmark process, which were BIS central bankers’ speeches endorsed by the FSB. 1 These recommendations were in four main areas: benchmark methodology; execution of benchmark transactions; market conduct; and guidance on reference rates produced by central banks. Earlier this year, at the request of the chair of the FSB, Mark Carney, I chaired a group that summarised the progress in implementing the 15 recommendations one year on, drawing on information gathered by the foreign exchange committees (FXCs) and central banks in the major FX centres. We put out a progress report on FX benchmarks just over a month ago. 2 I will provide a quick summary of what has happened in this space over the past year and briefly highlight some areas where there is still more to be done. In terms of benchmark methodology, we made a number of recommendations concerning how WM calculate the London 4pm fix. In particular, we recommended widening the fixing window, and as a result, from February 15, WM widened their calculation window from one minute to five minutes. This widening of the window appears to be helping to achieve the intended outcomes and the progress report contains some data analysis to support this. It is early days yet, with only a few month-ends (where flows through the fixing window are generally the largest), but so far, it would appear, so good. If you are interested I would recommend reading Section 3 of the report which compares the exchange rate dynamics before and after the change in the window for a number of currency pairs including the Aussie ($US/$A). The wider window has also helped to highlight the risk transfer involved between the buyside firm initiating the transaction and the sell-side firm executing it for them. This in turn was very helpful in the communication of another of our recommendations, which garnered quite a lot of attention, namely that fixing transactions should be charged for. Previously, transactions were often executed for free, at least notionally. The “free” cost of the transaction probably increased the incentive for manipulation as trading desks sought to generate greater profitability to compensate for taking on this risk. The widening of the window in February served as a focal point for sell-side firms to start charging for these services. Most sell-side respondents to the FXCs’ surveys report that they are now charging for fixing transactions, particularly those linked to the London 4pm fixes and especially the most liquid currency pairs. That said, some respondents, who tended to be smaller banks less active in the fix, reported they were still reviewing their pricing structure for benchmark orders. Moreover, while there had been good progress in terms of the London fix, there was much less progress for other fixes. However, the scope for benchmark manipulation is there for all fixes, not just the London 4pm fixes, and hence it is important to reiterate that the recommendations of our report are intended to apply to all FX benchmarks, not just the London 4pm. So how are fixes being charged for? A mix of pricing strategies is being used. Some are applying a bid-offer spread, some a fixed fee, where the fee is based on an assessment of the risk transfer involved. Others are pursuing a strategy which could be called “rent my algo”, where a firm provides access for a fee to an algorithmic trading tool to directly execute their fixing transaction in the fixing window. This in turn, leads me to another of the recommendations of the report, namely that banks should establish separate processes for handling and executing their fixing orders from other These recommendations were contained in a report published by the FSB that is available at <http://www.financialstabilityboard.org/wp-content/uploads/r_140930.pdf>. The progress report is available Benchmarks-progress-report.pdf>. at <http://www.financialstabilityboard.org/wp-content/uploads/FX- BIS central bankers’ speeches orders. This recommendation was designed to address potential conflicts of interest arising from managing customer flow. A sizeable number of banks have implemented this recommendation by shifting the execution of fixing orders from the spot voice FX trading desk to electronic trading desks that execute them with algorithms. As a result, the share of fixing orders executed by algorithm has increased substantially, as we document in the progress report. There is also considerably enhanced internal scrutiny from senior management around fixing transactions. Some firms have physically separated their fixing desk from other desks. This segregation of trading functions has involved some cost. Other participants regarded the cost of implementing this recommendation as being too high, given the size of their business, and have not implemented it to date. Others have decided to cease offering this service directly, in some cases offering customers a portal to other fixing services instead. Again, I would like to emphasise that the intention of our recommendations was that it was to apply to all participants, with appropriate consideration to the size and structure of the market. In the case of smaller, less actively traded currencies, separation of business is clearly more complicated than for large actively traded currencies, but in these cases participants should still be able to demonstrate to their customers that appropriate processes are in place, in keeping with the fundamental motivation of the recommendation to reduce the scope for benchmark manipulation. In terms of market conduct, we made a number of recommendations around appropriate sharing of information, including around trading positions (beyond that necessary for a transaction) and particularly customer information. These were picked up in a statement of Shared Global Principles that was published following the Global FXC meeting in Tokyo earlier this year. 3 Many market participants have reflected these principles in their internal policies and codes of conduct, as well as revised policies around benchmark execution consistent with our recommendations. FX code of conduct More broadly in terms of improving market conduct, in May this year, the BIS Governors commissioned a working group of the Markets Committee of the BIS to facilitate the establishment of a single global code of conduct for the FX market and to come up with mechanisms to promote greater adherence to the code. 4 I am chairing this work, with Simon Potter of the New York Fed leading the work on developing the code and Chris Salmon of the Bank of England leading the adherence work. 5 Our group comprises representatives of the central banks of all the major FX centres. It is very much a global effort. We are being supported in this work by a group of market participants, chaired by David Puth of CLS, that contains people from all around the world on both the buy-side, including corporates, and the sell-side, along with trading platforms and non-bank participants. The intention is to have this work of developing a single code to replace the various regional industry codes completed by May 2017. However, we intend to put out some parts of the global code, including some material on order handling and execution, by May 2016. I will talk more about this next week at the FX Week conference in London. So why have I taken the time to run you through all of this? These principles are available at: http://www.rba.gov.au/afxc/about-us/pdf/global-preamble.pdf. http://www.bis.org/press/p150511.htm. http://www.bis.org/about/factmktc/fxwg.htm. BIS central bankers’ speeches As market participants, regardless of which side of the market you are on, it is important that you are aware of the changes that have occurred, and are still underway, in the foreign exchange market. If you are on the sell-side, I would trust that you are well aware of these changes, and hopefully, I have provided you with some of the background and motivation for them. There is a fuller articulation of this in the FSB report itself. As I said earlier, particularly if you are in the asset management business, you may not have paid so much attention to the FX aspect of your business. But it is important that you also understand the context for the changes that are occurring. Some practices that you were accustomed to in the past, or maybe were unaware of, may no longer be available, and you cannot expect your counterparty to provide them. The motivation for these changes is to reduce the incentive and opportunity for improper trading behaviour by market participants around benchmark fixes. The implementation of the recommendations in our report, together with the enhanced scrutiny externally and within organisations on fixing transactions appears to have moved the market in a favourable direction. As we develop the single code of conduct for the FX market, hopefully the market will move further in that direction and allow participants to have much greater confidence that the market is functioning appropriately. Interest rate benchmarks Let me now turn to interest rate benchmarks. In light of the issues around LIBOR and other interest rate benchmarks, there has been a global reform effort also under the aegis of the FSB to improve the functioning of interest rate benchmarks. 6 Interest rate benchmarks are integral to the plumbing of the financial system. Many financial contracts reference interest rate benchmarks. The interest rate on a corporate loan is often a spread to an interest rate benchmark. Derivative contracts generally are based on them, as are most asset-backed securities. I will focus on the local market, where the primary interest rate benchmark is the bank bill swap rate (BBSW). BBSW As you may be aware, a few weeks ago, the Council of Financial Regulators issued a consultation paper on possible reforms to BBSW. 7 I will run through the motivation for doing so as well as the possible options we canvassed in the consultation paper. Given its wide usage, BBSW has been identified by ASIC as a financial benchmark of systemic importance in our market. 8 Hence it is important there is ongoing confidence in it. As you may know, BBSW was calculated for a number of years by, each day, asking a panel of banks to submit their assessment of where the market was trading in Prime Bank paper at a particular time of the day. While it was a submission-based process, it was different from See the FSB’s report on Reforming Major Interest Rate Benchmarks released in July 2014, available at: http://www.financialstabilityboard.org/wp-content/uploads/r_140722.pdf; and the July 2015 update on progress, available at: http://www.financialstabilityboard.org/wp-content/uploads/OSSG-interestrate-benchmarks-progress-report-July-2015.pdf. The consultation paper is available at: http://www.cfr.gov.au/publications/consultations/evolution-of-the-bbswmethodology/. See ASIC’s report on Financial Benchmarks, Report 440, released in July 2015, available at: http://download.asic.gov.au/media/3285136/rep440-published-8-july-2015.pdf. BIS central bankers’ speeches LIBOR in that it was the assessment of the borrowing cost of a notional Prime Bank, informed by observable transactions, rather than an assessment of a submitting bank’s own borrowing costs. In response to the prospect of a large number of the banks on the submission panel no longer being willing to provide submissions, the calculation of BBSW was reformed in 2013 in line with the International Organization of Securities Commissions’ (IOSCO) Principles for Financial Benchmarks, which were issued in July 2013. 9 Since 2013, the Australian Financial Markets Association (AFMA) calculates BBSW benchmark rates as the midpoint of the nationally observed best bid and best offer (NBBO) for Prime Bank Eligible Securities, which are bank accepted bills and negotiable certificates of deposit (NCDs). Currently, the prime banks are the four major Australian banks. The rate set process uses live and executable bid and offer prices sourced from interbank trading venues approved by AFMA, which are currently ICAP, Tullett Prebon and Yieldbroker. The bids and offers are sourced from three times around 10am each day. While the outstanding stock of bills and NCDs issued by the Prime Banks has increased since 2013 to around $140 billion, trading activity during the daily BBSW rate set has declined over recent years. The consultation paper illustrates how low the turnover currently is. There are quite a number of days where there is no turnover at all at the rate set. The low turnover in the interbank market raises the risk that market participants may at some point be less willing to use BBSW. This is the motivation for the CFR’s consultation to ensure that BBSW remains a trusted, reliable and robust financial benchmark. Some preliminary data collected from the four major Australian banks indicate that there is substantially more activity in the NCD market than is being measured at the rate set, with the activity mainly occurring outside the interbank market. At least $100 million in NCDs were bought or sold on almost all business days, with activity almost entirely at the 1-, 3- and 6month tenors. However, the non-bank participants that buy and sell NCDs tend to transact bilaterally with the issuing bank, with the price struck at the (yet to be determined) BBSW ahead of the actual rate set, rather than at a directly negotiated rate. If these participants could be encouraged to buy and sell NCDs at outright yields, then these transactions may have the potential to underpin the BBSW benchmark. Hence the consultation paper proposes one option for reform which would be to continue with the current NBBO calculation methodology, but to underpin the executable prices with a broader set of NCD market transactions contracted up to the time of the rate set. By more firmly anchoring the BBSW benchmark to observable transactions entered into at arm’s length between buyers and sellers in the market, this may ensure that the benchmark remains a credible indicator of rates in the market. For this option to be feasible, it would be necessary for the banks to directly negotiate the interest rates on their NCDs with third parties, rather than linking the rate to BBSW. This would require a change to the existing market practice. (In this regard this option has some similarities with the FX benchmark reforms where prior to the reforms, participants also agreed to transact at a yet to be determined price and at the midpoint of the fix.) Another option for reform, akin to the proposed methodology for LIBOR, would be for the banks to submit to the benchmark administrator their assessment of their aggregate cost of wholesale funding, based on their transactions in a particular window. That is, the banks would do the aggregation and the administrator would only need to average the (currently) four submissions. An alternative option would be for the banks to submit all their The IOSCO Principles for Financial pubdocs/pdf/IOSCOPD415.pdf. BIS central bankers’ speeches Benchmarks are available at: https://www.iosco.org/library/ transactional data to the benchmark administrator who would then itself do the aggregation. Both of these options would need to provide for circumstances in which the Prime Banks had not executed any transactions in the relevant window. The final option would be to accept the current system as it is, notwithstanding the very low turnover at the rate set. The consultation is open until 3 December. 10 Given the importance of BBSW for the market, if you have any interest in the issue, I would ask that you consider making a submission. Risk-free rates Next I would like to briefly raise some issues around whether the use of BBSW needs to be quite as widespread as it is. In a number of instances, BBSW has become the default reference rate without much thought being given as to whether it is the most appropriate reference rate. BBSW is a credit-based reference rate. It is based on the borrowing costs of the major banks, with the credit risk that entails embodied in the rate. For a number of purposes, such a credit-based rate is completely appropriate. However, for other purposes, a rate that is closer to risk-free may be more appropriate. For instance, in recent years, market participants have moved to use overnight-indexed swap (OIS) rates more often when discounting the cash flows in their swaps. The FSB, through its official sector steering group (OSSG) on benchmark reform, is encouraging market participants to contemplate switching from credit-based benchmark rates like BBSW or LIBOR to risk-free rates, where appropriate. We are working with AFMA in the local market to encourage market participants to consider this. One example where a change in reference rate could be contemplated is for residential mortgage-backed securities (RMBS). RMBS coupon payments are typically priced at a spread to 1-month BBSW. Since the introduction of the Liquidity Coverage Ratio, banks have little incentive to issue 1-month paper, since they would need to hold high-quality liquid assets against the funds raised. If they do issue, then the pricing will be different from the past. A rate based on the cash rate may be a more appropriate benchmark. Such a rate could be backward looking, like the actual cash rate itself, or forward looking, like OIS rates. Alternatively, a benchmark rate of 90 day BBSW which more robustly reflects bank funding costs, may be worth thinking about. That is one example worthy of consideration. There are a number of others. I know this is not necessarily an issue you may have thought that much about until now. At the very least, I would encourage you to at least ask the question whether the product you are issuing or holding is using the most appropriate reference rate. Cash rate Finally, I will briefly mention the cash rate. As the RBA’s operational target for monetary policy and the reference rate for OIS and other financial contracts, the cash rate is another systemic benchmark. Consequently, we are making sure that our methodology for the cash rate is also in line with the IOSCO benchmark principles. We are in the process of ensuring that our data collection is capturing all cash market trades appropriately and that we can match data from both sides of the transactions. This will entail a few changes but we do not expect these to have any material impact on the calculated outcome for the cash rate. Responses can be sent to [email protected]. BIS central bankers’ speeches Conclusion Let me conclude. You’ve probably heard more today about benchmarks than you ever really wanted to hear. But benchmarks are a very critical part of the plumbing of the financial system. It is important that market participants have a reasonable awareness of how they are calculated rather than simply taking them for granted. But even more importantly, market participants need to have confidence in their robustness and integrity. To help ensure that is the case, a number of reforms to benchmarks have been undertaken. But the process is still ongoing to make sure this part of the market gets to a better place than where it has been in the past. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 11 |
Remarks by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the UBS Australasia Conference 2015, Sydney, 17 November 2015. | Christopher Kent: Slowdown in China’s growth - implications for Australia Remarks by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the UBS Australasia Conference 2015, Sydney, 17 November 2015. * * * I thank Ivan Roberts for help in preparing these remarks. I would like to thank UBS for the opportunity to participate in this conference. Given its importance to the Australian economy, the Bank monitors developments in China closely with a team of economists in both Sydney and Beijing. The easing in the growth of the Chinese economy over the past year or so has two related parts. The economy is slowing as it matures, and this is to be expected. Overlaying that, there has been a substantial slowing in the industrial sector, linked in part to earlier excesses in construction. How all of this will play out and the effects on the Australian economy are uncertain. I’ll briefly highlight some possibilities. Let me be clear though, many of these have positive implications for our economy. It is natural for the speed of China’s economic development to ease and for its nature to evolve: • Part of this reflects slower growth of the working-age population, which is now in decline. Other than increasing the retirement age, there is little that can be done to alter that in the coming years, notwithstanding the ending of the one-child policy. • However, growth continues to be supported by the process of urbanisation, which uses commodities intensively. This has further to run, albeit at a more gradual pace. • Productivity growth appears to be slowing as windfall gains from earlier reforms have waned. But there remains a large gap between productivity in China and in advanced economies. That gap could be closed more quickly via additional reforms to allow a greater role for market forces in allocating productive resources. The authorities have expressed support for such reforms. • The authorities would also like to see growth rebalancing from investment towards consumption. That is happening gradually. It is also being accompanied by a rise in the share of activity accounted for by the services sector as the economy develops and household incomes rise. While these longer-run changes imply a decline in the growth rates of investment and industrial production, both have also experienced a noticeable cyclical slowing over the past year or more. As earlier excesses in residential construction gave rise to a large stock of unsold housing, house prices declined and so too did housing construction. Sales and prices have recovered a bit since the start of this year, but there is little sign to date of a sustained improvement in construction activity. Weakness in construction has been accompanied by declines in output of a range of manufactured products over the past year.1 Steel is one obvious example. Mining activity in China has also been affected. Indeed, a further decline in the output of unprofitable Chinese mines would provide some support to commodity prices, and would benefit other producers, including in Australia. The substantial appreciation of the renminbi over the past year (12 per cent in trade weighted terms) may also have contributed somewhat to the weakness in the industrial sector BIS central bankers’ speeches Although the weakness in China’s property and manufacturing sectors is clearly of concern to commodity exporters like Australia, there are a number of countervailing forces supporting broader activity in China. • First, growth in the services sector has been resilient, and should continue to be assisted by a shift in demand toward services as incomes rise. • Second, growth in household consumption has also been stable in recent quarters aided by the growth of new jobs.2 Of course, such outcomes cannot be taken for granted; if the industrial weakness is sustained, it might eventually affect household incomes and spending. • Third, Chinese policymakers have responded to lower growth by easing monetary policy and approving additional infrastructure investment projects. They have scope to provide further support if needed, although they may be reticent to do too much if that compromises longer-term goals, such as placing the financial system on a more sustainable footing. There are two key implications of the slowing in China’s growth for Australia. First, the substantial slowing in industrial production has contributed to a further decline in commodity prices over the course of this year. (This is in addition to the contribution from the substantial increase in the supply of commodities, including from Australia.) We’ve detailed the effect of the decline in commodity prices on Australia’s economy elsewhere.3 I would just add that commodity prices remain relatively high. The Bank’s index of commodity prices has fallen by about 50 per cent from its peak, but is still almost 80 per cent above early 2000 levels. Clearly, conditions in the industrial sector in China, and Asia more broadly, will have an important influence on the path of commodity prices over the near term. Beyond that, the changing nature of China’s development implies that the potential for commodity prices to rise from here is somewhat limited. Second, the shift in demand towards services and agricultural products within China and the Asian region more broadly presents new opportunities for Australian exporters. While our comparative advantages in service industries are perhaps less obvious than they are for mineral resources, the rise in the demand for services from a large and increasingly wealthier populace in our region will no doubt be to our benefit. The 2015 target of 10 million new urban employed workers was apparently exceeded in the first three quarters of the year. See Gorajek A and D Rees (2015), ‘Lower Bulk Commodity Prices and Their Effect on Economic Activity’, RBA Bulletin, September Quarter. 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Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business Economists (ABE) Annual Dinner, Sydney, 24 November 2015. | Glenn Stevens: The long run Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Australian Business Economists (ABE) Annual Dinner, Sydney, 24 November 2015. * * * I thank Emily Perry for assistance in compiling these remarks. Thank you for the opportunity to address you this evening. You've spent all afternoon talking about the near-term outlook. No doubt there was a lively discussion and some points of debate. I would hazard a guess that most forecasts have the Australian economy continuing to expand at a moderate pace, with inflation low and the rate of unemployment around 6 per cent. The points of debate might be around whether, and when, growth might speed up a bit or slow down; whether inflation would be broadly consistent with the 2–3 per cent target or a bit on the low side; and whether unemployment could start to drift down, or instead, might resume its drift up. The Reserve Bank released its own views about the outlook a few weeks ago. These left the forecast for growth about where it was before. Over the next couple of years, as the drag from the decline in mining investment starts to lessen (mainly in 2016/17), and the effects of assumed low levels of interest rates and the exchange rate continue to accrue, growth is thought likely to pick up a bit. A number of data points over recent months suggest that prospects for firmer conditions in the non-mining economy are improving. Business surveys indicate that firms report conditions to be, if anything, above their long-term average in some key sectors. Firms seem to have stepped up their hiring. Job vacancies have been increasing, hours worked have been increasing and employment growth, even before the most recent month's data, had strengthened noticeably over the past year. Labour force participation has risen, and the unemployment rate has been stable. This is supporting income growth as the terms of trade decline works its way through the economy. The Bank did lower its forecast for inflation a little. This was based on an assessment that the latest reading contained some signal, not just noise. As in the case of many other countries, the effects of a decline in the exchange rate are proving a bit slow to come through. And slow wage growth makes for a low underlying rate of increase in domestic costs. On this basis, the Board concluded that inflation would not be a barrier to further easing of monetary policy, should that be useful to support demand. But there is little numerical precision that can be attached to these rather qualitative views. For a few years now the Bank has sought to emphasise the idea of the outlook being probabilistic. The “central forecast” is simply the modal point of a distribution of possible outcomes. It is more likely, in our judgement, than any other single outcome, but the likelihood of that particular outcome is in fact not that high at all.1 We have tried to convey this sense of imprecision by publishing “fan charts” and by putting ranges in tables for forecast variables over horizons longer than a couple of quarters. The point of this is to try to get people to focus less on the central number and more on the set of issues that accompany the forecasts. It seems that we have not been very successful on that score. There still seems to be inordinate attention paid to changes in the central forecast that are often no more than a couple of tenths of a percentage point. I've debated at times with our staff whether we should leave the central If, for example, the ‘central’ forecast for underlying inflation two quarters ahead is 2 per cent, the statistical likelihood of an outcome of 2 per cent +/– 0.125 per cent, is about 25 per cent, if forecast errors are assumed to be drawn from the same distribution as in the past. BIS central bankers’ speeches line off the fan charts altogether. The response is that people would simply back it out of the charts. Likewise, the desire I often feel to put wider ranges in the forecasts would probably still result in people just computing the mid-point of the range, ascertaining whether that had moved slightly and offering interpretation of that change. It's a natural human tendency to focus overly on small changes, perhaps because it allows us to maintain the comfortable illusion that things are predictable and controllable. But this fervent desire for precision is not supported by any demonstrated accuracy of economic forecasts. Its cousin, a hankering for policy fine-tuning, is barely, if at all, better supported by the historical outcomes of economic policymaking. While small forecast changes get a lot of attention, the far more important question is whether we have recognised and understood the big forces at work. Even if we cannot predict the outcomes with great accuracy, an understanding of these forces ought to help us get policy responses roughly right. And that, in the real world, is probably about as much as we dare hope. Right now the big forces include: • for Australia, the closing chapters of a very large and long-running terms of trade event, with all that means in terms of economic adjustment. This coincides with a household sector no longer being in a position to play a major role in leading growth by significantly increasing its leverage, because it had already done that in the past; • a global economy growing but only moderately, affected by considerable structural change and facing legacy effects of debt, arising from a previous period of overconfidence and under-appreciation of risk; • a disinflationary or deflationary environment for the production of goods and commodities, and even some services, accompanied by unusually low rates of wages growth; • extremely low returns on safe financial assets, as central bank actions have removed a significant proportion of these assets from the market, and have encouraged investors to accept interest rate risk on the remainder by providing “guidance”, leading to: • high and rising valuations on existing fixed assets, including dwellings, around the world, but not so much, thus far, in the way of new capital formation by most existing businesses in the “real” economy. To this list of “conventional” forces we might add: • the “disruption” of the increasing application of digital technology, which may mean, among other things, that growth in sales, capital formation and returns to capital are happening in entities and activities we don't measure very well – or at all. Many of these sorts of forces are low-frequency in their nature. Most of the ups and downs in the time series from month to month, or even year to year, on which we all expend so much energy are just temporary fluctuations around these longer-run trends. If numerical forecasts can't be very dependable, are we – the economics community – much good at predicting these long-run forces? If we look back a decade, to the sorts of things that occupied much attention, the evidence is mixed. By the middle of last decade, we had certainly noticed the change in household borrowing and spending behaviour, understood that it was important and wondered how long it could continue, and what might cause it to alter course again. In that respect, we were at least looking in one of the right places. People had also sensed that the emergence of China was starting to have important implications for Australia and the global economy. That said, the strength and duration of the BIS central bankers’ speeches “China boom” tended to be under-estimated. In forecasts made over a succession of years, people routinely tended to expect that the strong growth then being observed in China would slow. Likewise, through most of the period in which Australia's terms of trade were rising, forecasters routinely tended to call a near-term peak followed by a decline - and were wrong in most years.2 Even those resource companies that would eventually make massive investments on the back of the rise in commodity prices were initially sceptical. Now, as this period of exceptional, and not well forecast, Chinese growth has ended and we face less spectacular outcomes, a few have been surprised on the downside. A decade ago, everyone was celebrating the “great moderation” – that period of reduced macroeconomic volatility, good average growth and low inflation. This was regarded as a success of macroeconomic policy. It was also thought that the development of modern financial tools, with fairly light regulation, had helped us to understand, unbundle and disperse risk around the system. To be fair, there were some voices questioning compressed risk spreads, leverage and so on. Some worried about the complex interactions between the various players and how the system would cope in a stressed environment. Some wondered whether apparent stability would lead people to take on leverage to the point where it would threaten that very stability.3 A few presciently placed financial bets against the prevailing trend. But, overall, very few foresaw either the severity of the crisis that would unfold or the longevity of its adverse economic effects. If we look at what featured in most discussions about risks to global growth at the time, we find that the so-called “global imbalances” were prominent. It was not uncommon to hear people worry that markets would at some point decline to “fund” the US current account deficit, leading to a crash in the US dollar. Yet it wasn't the global imbalances that caused a crisis. It was the implosion of complex financial products, against the backdrop of excessive leverage, that ushered in the crisis. It was the drying up of dollar funding liquidity in the financial systems of several major countries that propagated it. The onset of the crisis saw a shortage of dollars in the market, not a glut. And the “global imbalances” continue today, though they have diminished in size. A decade ago, Japan was experiencing deflation, “ZIRP” – zero interest rate policy – and “QE” – quantitative easing. People offered various analyses of this; many opined that it should not be that hard for the central bank to return to inflation, by sufficiently aggressive action. Thoughtful people pondered the difficulties Japanese policymakers confronted and hoped never to find themselves in that situation. Ten years on, policy interest rates have been effectively zero in the United States, the United Kingdom and Europe for quite a long time. They are still zero in Japan. “Quantitative Easing” by one name or another has become more widespread. Central bank balance sheets in these cases are a multiple of their sizes in the mid 2000s. I recall few, if any, who a decade ago saw that outcome as having a significant probability. While outright deflation is still comparatively rare, inflation being a bit too low relative to announced objectives seems to be not uncommon. It is difficult to avoid the conclusion that, in practice, it is more difficult than the textbook says it should be for a central bank (by itself) to create inflation, when other powerful forces are at work. For economists and policymakers See Health, A (2015) ‘The Terms of Trade: Outlook and Implications’, Address to the Resources and Energy Workshop hosted by the Department of Industry, Innovation and Science, Canberra, 20 November. On these points, see for example Geithner, T (2006), ‘Hedge Funds and Derivatives and Their Implications for the Financial System’, Remarks at the Distinguished Lecture 2006, Hong Kong, 15 September (available at <https://www.newyorkfed.org/newsevents/speeches/2006/gei060914.html>) and Stevens, G (2006), ‘Risks and the Financial System’, Remarks in response to Distinguished Lecture by Mr Timothy Geithner, Hong Kong, 15 September. BIS central bankers’ speeches trained from the 1960s to the 1990s, when the task was always to stop inflation rising and/or to get it down, this is a remarkable outcome. One area in which good long-term thinking was being done a decade ago was population ageing. Australian work in this field foreshadowed adverse long-run trends in the fiscal balance. And we can find GDP growth projections from Intergenerational Reports from a decade ago that put average growth between 2010/11 and 2015/16 at 2¾ per cent, noticeably below the growth rates being observed at the time this projection was made. That was not a bad “forecast”, actually: the outcome is likely to be about 2½ per cent. This is despite the fact that the people who made this estimate obviously could not have had any knowledge of many of the non-demographic forces that would be at work over the relevant years. One can't help but observe that, in common discussion about the economic outlook, we too often ignore the influence of demography. But it may be that demographic forces are a common factor behind some of the most important “big force” developments. It seems likely that the characteristics of the “baby boom” cohort – its relative size and different propensities from those of other generations – have affected saving and investment choices, housing markets, asset values, leverage and so on through time. Further effects no doubt will occur (not necessarily in the same direction).4 What then might be some of the “big forces” at work over the next decade? Perhaps unwisely, I shall chance my arm at some ideas. In so doing, I am comforted by the very low likelihood that I shall have to return to a future ABE forecasting conference to explain why these prognostications were wrong! It is not very controversial to suggest that China will grow more slowly on average than in the past decade, but it will still be a big deal given its overall size and the extent of transition required in its growth strategy. China's financial weight will be increasingly apparent in markets. Those days, like in late August this year, when US and global markets are roiled by some event in China, will probably become more common. The growth transition towards services will have implications not just for the value of resource shipments from Australia, but for the Asian regional manufacturing chain. But China's demographics are not favourable. To be sure, the continuing process of urbanisation means that the labour available for manufacturing or services production may grow for a while. But, overall, China's total working-age population will be shrinking over the years ahead. Contrast this with India, another large country, but with vastly different demographics. India's population of working age will exceed China's within a decade and continue to grow.5 So India should become much more prominent in our conversation about the global economy and our own. Are we intellectually prepared for that? The United States will still be a very large economy and, perhaps more important, still a leading source of innovation and dynamism. It will probably retain its current position of global leadership in international economic governance, though much depends on how two political establishments – the US's and China's - behave, including towards each other. There are no prizes for guessing that the share of services in most economies will continue to increase. Health and aged care are obvious areas for expansion – another effect of demographics. It may be that jobs will be “robotised”. But on the other hand, in the long run we See, for example, Kulish, M, K Smith and C Kent (2006), ‘Ageing, Retirement and Savings: A General Equilibrium Analysis’, RBA Research Discussion Paper 2006-06. The UN projects India's total population to surpass China's in seven years and the working-age population to surpass China's in 2025. The UN projects India's working-age population to increase by 250 million by 2040, to 1.11 billion (compared with 866 million in China). BIS central bankers’ speeches may need that to some extent. Demographic factors suggest strongly that, all other things equal, the problem isn't going to be a shortage of jobs, but instead a shortage of workers. ‘Digital disruption’ will continue. Some of this will be faddish and no great aid to productivity. But other elements will mean fundamental changes to business models. It's already obvious that models that rely on having an information advantage over a customer are struggling as information becomes ubiquitous. Models that can profit by using more information about the customer will be advantaged – up to the point at which customers decline to reveal any more about themselves. The issue of trust will be key. On that note, I suspect the already-considerable resources devoted to IT security will grow further as awareness increases of cyber risk and its consequences. Maybe IT security will need to get as inconvenient as airport security and more costly – a whole new meaning of the term “digital disruption”. It remains to be seen whether, at some point, the potential risks of further connectedness might be judged to outweigh the benefits. There are, for example, some organisations sufficiently concerned about cyber risk that they construct a duplicated IT architecture – one connected to the world, the other sealed off. The issue of trust in cyber space may turn out to be every bit as problematic as that of trust in the financial system. My guess is that global interest rates are still going to be very low for a good part of the decade ahead. Clearly there is a likelihood that the Federal Reserve will raise the fed funds rate next month or, if not then, pretty soon. Once it does, intense speculation will begin about a question much more important than the timing of the first increase, namely the timing of the second (and, by extension, the future path of the funds rate). But it seems likely that the pace of increase will be very gradual. The ECB and the Bank of Japan are a long way from even thinking about higher interest rates; the ECB is openly contemplating further easing. So the average policy rate in major money centres may be very low for quite a while. In a low interest rate world, the problems of providing retirement incomes will become ever more prominent. The very low level of yields on fixed income assets means that it is very expensive today to purchase a secure stream of future income, which is what someone who is retiring is usually seeking. And there are more of such people, living longer. The retiree can of course respond to this by holding more of her portfolio in dividend-paying stocks – accepting more risk. She may hope for a dividend stream that is fairly stable from year to year but that tends to grow over time. It certainly seems that many Australian listed corporates feel the pressure from shareholders to deliver that, even some whose earnings are inherently volatile. Can the corporate sector realistically promise growing dividends over a long period? Not without being prepared to take the risk on investment in new products, processes and markets. How much of that risk an older shareholder base will allow boards and managements of listed entities to take is an important question. Overall, in a world where a higher proportion of the population wants to be retired and living (even if only in part) off the return on their savings, those returns are likely, all other things equal, to be lower. Part and parcel of the same adjustment may be higher real wages for the smaller proportion of the population that is working. These changes, driven by demographics, may require some adjustment to our collective thinking about what is “normal”, not just for rates of return on assets but also for returns to labour. My final, fairly uncontroversial predictions: • The business cycle will continue. There will be economic downturns from time to time. If one of those turns out to be a big one, it will be very new experience for quite a lot of Australians. Close to half the workforce has never seen really high, nationwide unemployment. A lot of people in business have, I suspect, not seen how tough conditions can become when virtually every industry and region is contracting. That they have not seen this is a good thing – in the sense that it results from the fact that BIS central bankers’ speeches we have not a really serious downturn for a long time now. But if one comes, it will be a shock. • A decade from now, I suspect the art of economic forecasting won't have changed much. In my 35 years as a maker, observer and user of forecasts, I think forecasts have improved. Part of that has come from learning more about how economies work. But a lot of it, I suspect, has come from what could be described as improved “nowcasting”: finding ways of assimilating a host of disparate pieces of information to judge more accurately what the economy has been doing in the very recent past. (That's probably where “big data” potentially has some use.) That provides a better “jumping off” point for the forecast profile, which is important because most revisions to numerical forecasts for annual growth or inflation still seem to come from surprise about the current and most recent previous quarter. When all is said and done, however, it remains the case that “forecasting is hard, especially about the future”.6 • But, finally, human nature won't change. That means that we, as human beings, will be irresistibly drawn to those who claim to be able to forecast the future, beat the market, and give us the illusion of certainty and control. So there will continue to be interest in forecasts, and the ABE forecasting conference will, I'm sure, go from strength to strength. Thank you. The UN projects India's total population to surpass China's in seven years and the working-age population to surpass China's in 2025. The UN projects India's working-age population to increase by 250 million by 2040, to 1.11 billion (compared with 866 million in China). BIS central bankers’ speeches | reserve bank of australia | 2,015 | 11 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to an Australia-Israel Chamber of Commerce (WA) Corporate Breakfast, Perth, 2 December 2015. | Glenn Stevens: After the boom Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to an AustraliaIsrael Chamber of Commerce (WA) Corporate Breakfast, Perth, 2 December 2015. * * * It is very good to be back in Perth. As you know, the Reserve Bank Board held its meeting here yesterday. We decided to leave the cash rate at 2 per cent. The reasoning was given with the decision, and so I don't propose to discuss that. Instead I want to reflect on the nature of the adjustments going on in the economy, and in which Western Australia is very important. It is four years since the Board last met here. The previous occasion was in September 2011. I don't need to tell you that quite a lot has changed in the intervening period. At that time, the price of a tonne of iron ore was about US$170. A tonne of hard coking coal was bringing in about US$300. These were among the prices that saw Australia's terms of trade soar to a level some 75 per cent above their average for the preceding century. Few countries have seen such a windfall. These extraordinary prices had already, by that time, triggered a massive investment program, which was lifting capacity. Four years ago, Australia was shipping about a million tonnes of iron ore each day, which was already double the rate of 2004. A bit under a million tonnes of coal left our shores daily. By 2011, capital spending by the resources sector had already roughly trebled since 2005. It would peak the following year after rising by a further 50 per cent. The results of that investment have come on stream, or soon will. Today, Australia ships around 2 million tonnes of iron ore and 1 million tonnes of coal per day. The investment was not just in iron ore and coal. On forecasts of strong demand from Asia – not just China but Korea and Japan as well – massive investments are under way in gas. LNG exports have begun from some of the Queensland projects and are expected to increase strongly over the coming years. As the WA projects come on line in the next few years, Australia's total LNG production capacity will reach over 80 million tonnes per year. This compares with a production capacity of around 10 million tonnes a decade ago. I should note in passing here that I have felt that we have been given a pretty good steer on the magnitude of the investment build-up and the early stages of the reversal, on the back of the very good work done by our regional liaison people, especially here in Perth. As a result, we've been much better at forecasting investment in the resources sector than in the other industries. That's because of the help we were given by the large players in the resources industry. I know that many of you have participated in these discussions, which have been extremely helpful in understanding the nature of the episode. So I want to thank you for helping in that way. As it happens, about the time the Board was meeting here in 2011, resource prices and Australia's terms of trade were about at their peak. And what a peak it was. On a ten-year average basis, the terms of trade exceeded anything seen for at least a century. This was not just a very brief spike like some commodity price events have been (such as the early 1950s rise in the price of wool). It was quite persistent. Not permanent, but quite persistent. Nonetheless, the peak was four years ago. Since then, as you know, prices have fallen considerably. Today the price of iron ore is about US$40 per tonne, and coking coal around US$75. At a national level, Australia's terms of trade, having been through an extraordinary surge, have fallen by a third and are still declining. BIS central bankers’ speeches But even at those reduced prices, iron ore is still bringing a price 60 per cent higher than it did in 2000. Natural gas prices are 50 per cent or more above their 2000 level. The terms of trade, though down a long way from the peak, are still nearly 30 per cent higher than their 20th century average. Of course they may yet fall further. Time will tell. In the meantime, many resource companies are making significant strides in reducing their production costs so as to remain viable, and in some cases still very profitable, at these reduced prices. That's consistent with most experience in the long history of the resources business. Australia's presence in these markets is greater now. It would be true to say that, though weaker demand is part of the story, a significant part of the fall in prices is a result of increased supply from this continent. The ‘super-cycle’ in commodity prices, and the associated surge in capital spending, have been of national and international significance. At times, the price of iron ore has even, on occasion, displaced from page one of newspapers the price on which Australians typically focus most intensely – that of a house. The spill-overs of these activities have been felt around the country. For the fifty years up to 2005, resources sector investment had averaged just over 1½ per cent of national GDP. Periodically, in a boom it tended to reach a peak of perhaps 3 per cent of GDP. This peak was about 8 per cent – nearly three times the size of the ‘normal’ peak, and easily the biggest such surge for over a century. The resources sector was doing 40 per cent of the nation's total business capital spending. And, as you know, a big share of that was occurring here in WA. On other occasions, these types of events have ended up being very disruptive for the national economy. Terms of trade surges in the 1950s and the 1970s produced significant inflation on the way up and were followed by very major slowdowns or recessions in economic activity as the terms of trade fell back. That hasn't happened at a national level on this occasion. Inflationary pressure was relatively contained on the way up, and while aggregate growth has been a little disappointing for the past couple of years, in the circumstances we face – including very difficult global conditions in the aftermath of the financial crisis – the outcomes are, I think, quite respectable. In fact, in a number of respects the economy has adjusted to the shocks in the way you would hope. Productive resources were re-deployed to sectors where returns looked like they would be higher. This was true for capital but also for labour – relative wages shifted upwards in WA, for example. Population shifted in response, we had fly-in-fly-out and an immigration response, facilitated by visa arrangements and so on. These were helpful parts of the adjustment process. Likewise, the exchange rate adjusted, as would be expected in a flexible system. When we were here in early September 2011, the Australian dollar was trading around US$1.07 and had been as high as about US$1.10. Today it is about 35 per cent lower than that against the US dollar, and about 20 per cent lower against a relevant basket of currencies. This movement – both up and down – was part of what helped the economy through the commodity super-cycle without seriously inflating or crashing. Through all that, tested macroeconomic policy frameworks have aimed at overall stability, and the financial sector has been kept in good shape by sensible regulation and generally competent management. While the episode is not yet over, at this point the economy overall has been recording growth. We will very shortly get a reading on GDP and the various expenditure and income accounts for the September quarter. Looking ahead, nationally, the outlook appears to be for a continuation of moderate growth. The Reserve Bank issued its latest forecasts a few weeks ago. I won't go into detail here, but, in brief, year-ended GDP growth is forecast to be in the range of 2 to 3 per cent in June 2016 and to pick up a bit during the following year. Domestic inflationary pressures are expected to remain subdued. Inflation is forecast to be in the range of 1½ to 2½ per cent over the year to BIS central bankers’ speeches June 2016, and 2 to 3 per cent over the year to June 2017. The unemployment rate is projected to remain around 6 per cent or a little above over the next year, before gradually declining. We do not make detailed forecasts at state level, but obviously the picture for WA relative to the rest of the country looks different from the way it did a couple of years ago. Previously, economic activity was very strong in the west and the north-east, driven by the investment boom, while in the south-east of the country it was somewhat subdued. Now, as the mining investment boom in the west is in the reversal phase, economic activity here in WA is more subdued, while in the south-east it is picking up. These differences are plain in most of the economic data. Whereas business investment in NSW and Victoria is growing (albeit modestly), in WA it is, of course, contracting very sharply (as it is in Queensland). I think most people have understood for some time that this was on the cards. Consumer spending and employment growth in WA, which had outpaced the national average by a wide margin, have come back to be a bit below the national average. The rate of WA's population growth has slowed. Housing prices have declined a little, while those in Sydney and Melbourne have, at least until recently, risen at quite a clip. Measures of business conditions in WA are at about their long-run average, having been a long way above that for some years. So WA has ‘come back to the pack’, though the pack has actually picked up some speed in the meantime. Yet even with all that, employment in WA is still increasing. The unemployment rate has increased, though only to the national average so far. Going back a few years, WA had, at times, the lowest unemployment rate recorded of any state at any time over the past 40 years; on occasions there was a ‘2’ before the decimal place. That was obviously not going to be sustained indefinitely. And while labour market performance not is as strong as it was, it is still a good deal stronger than it was in episodes like 1983 or 1991–92. Interestingly, those periods of serious weakness in the labour market in WA were part of a national event. In the early 1990s, that event had little to do with mining and a lot to do with an asset price boom and bust, coupled with high corporate leverage. Of course, further adjustment in the resources sector is still ahead. Although most of the construction employment losses in the iron ore sector have probably occurred, the large LNG projects in WA are still in the investment phase. Over the next few years some labour presumably will be released from these projects. So it will be a while yet before we will be able to say that the difficult phase is completed. That aside, the point I want to offer is that it's worth remembering the positive legacy of the events of the past decade. The sheer scale of the investment that has been undertaken makes WA production, already a powerful force in some key commodities, more powerful. To be sure, prices are lower, but the quality of the resources, the attention to cost reduction and of course a lower Australian dollar are likely to leave many producers well placed. Of perhaps more direct relevance to the ordinary person has been the trend in income per head. In 2000, WA's per capita income was about the same as in Queensland or South Australia but lower than in either NSW or Victoria. But WA has seen easily the largest increase over the intervening period. Today WA enjoys the highest per capita income of any state, at around $50 000 per person per year. It is true that the ACT and NT boast higher figures, but they are very unusual cases, being heavily influenced by the effects of government employment and/or subsidies, not to mention being quite small. It would take quite a few years at the current pace of growth for the other states to catch up to WA. Household net worth in WA in 2013/14 (the latest available data), at about $950 000 per household, was a good deal higher than in any other state. Since then, housing prices in WA have declined while those in some other places have risen, so this gap may have diminished. Nonetheless, my guess is that, among the Australian states, the citizens of Western Australia BIS central bankers’ speeches are on average, probably still among the richest. Even if the others gradually close the gap over time, as they well might, you are better off for having had the boom. WA has unique endowments of resources. Mining has always been a cyclical business, which has long been understood. On this occasion, given the size of the boom, you've done a pretty good job of managing it. As a result, there will be permanently more income and wealth than there was before. Conclusion I expect that, in a few years' time, the Reserve Bank Board will once again meet in Perth. I imagine that, by then, the current contraction in capital spending will probably have reached an end. New opportunities for growth will have emerged, resulting from things like the growth in the middle class of Asia, with all what that means for demand for services as well as for energy and agricultural production. The growth of India is surely also a potential opportunity for WA – facing as you do the Indian Ocean, and with the advantage of relative lesser distance. A mere eight hour flight time! No doubt Western Australians will be looking to seize those opportunities. At the same time, this vast part of the Australian continent, endowed by nature with so many resources, will still be a major player in key commodities. Even if the extraordinary boom in investment was hard to digest, and even if some of the investments don't pay off quite as handsomely as hoped, it still seems that Western Australians will be richer for the experience. 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Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the FX Week Europe conference, London, 25 November 2015. | Guy Debelle: The global code of conduct for the foreign exchange market Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the FX Week Europe conference, London, 25 November 2015. * * * Thank you for giving me the opportunity to talk to you tonight about two important pieces of work currently occurring in the foreign exchange market. First, I will summarise developments in FX benchmarks. Second, I will talk about the global code of conduct for the foreign exchange market. But before that, let me step back and ask why is the work going on? The reason, as many of you are painfully aware, is that the foreign exchange industry is suffering from a lack of trust in its functioning. This lack of trust is evident both between participants in the market, but at least as importantly, between the public and the market. Trust is the lynchpin of all financial market transactions. Without trust, markets do not function well.1 At an FX Week conference earlier this year,2 my colleague Simon Potter outlined the important role that the foreign exchange market plays in the global economy. We clearly need the market to be functioning as effectively and efficiently as possible. But for that to happen, we need to restore the trust in the foreign exchange market. FX benchmarks I will start by summarising the current state of play in FX benchmarks, reiterating remarks I made in Sydney last week.3 Roberto Schiavi has talked about this from a European perspective earlier today. From early 2013, concerns were increasingly raised about the integrity of FX benchmarks, particularly around the potential for market misconduct in the trading around the time of benchmark fixings. Accordingly, the Financial Stability Board (FSB) formed a group co-chaired by Paul Fisher of the Bank of England and me to firstly analyse the structure of the FX market and the incentives that might promote inappropriate trading activity around a fix, and then come up with some potential remedies to address the problems we found. After talking to participants from all sides of the FX market around the world, in September 2014, we proposed 15 recommendations to reform the FX benchmark process, which were endorsed by the FSB.4 These recommendations were in four main areas: benchmark methodology; execution of benchmark transactions; market conduct; and guidance on reference rates produced by central banks. Earlier this year, at the request of the chair of the FSB, Mark Carney, I chaired a group that summarised the progress in implementing the 15 recommendations one year on, drawing on I spoke at length of this issue of trust in financial markets more broadly a few years ago: “Credo et Fido: Credit and Trust”, Deakin University 2012 Richard Searby Oration, Melbourne, 25 September 2012. Potter, S. “Trends in Foreign Exchange Markets and the Challenges Ahead”, Remarks at the 2015 FX Week Conference, New York City. Available at <https://www.newyorkfed.org/newsevents/speeches/2015/pot150714>. “Benchmarks“, Bloomberg Summit, 18 November 2015. These recommendations were contained in a report published by the FSB that is available at <http://www.financialstabilityboard.org/wp-content/uploads/r_140930.pdf>. BIS central bankers’ speeches information gathered by the foreign exchange committees (FXCs) and central banks in the major FX centres. We put out a progress report on FX benchmarks just over a month ago.5 I will provide a quick summary of what has happened in this space over the past year and briefly highlight some areas where there is still more to be done. In terms of benchmark methodology, we made a number of recommendations concerning how WM calculate the London 4pm fix. In particular, we recommended widening the fixing window, and as a result, from February 15, WM widened their calculation window from one minute to five minutes. This widening of the window appears to be helping to achieve the intended outcomes and the progress report contains some data analysis to support this. It is early days yet, with only a few month-ends (where flows through the fixing window are generally the largest), but so far, it would appear, so good. If you are interested, I would recommend reading Section 3 of the report which compares the exchange rate dynamics before and after the change in the window for a number of currency pairs. It is likely that the dynamics will continue to evolve as participants adjust their execution strategies and it will be interesting to see how that goes. There are also a number of propositions in the market in terms of netting of fixing transactions which will also shape these dynamics going forward. The wider window has helped to highlight the risk transfer involved between the buy side firm initiating the transaction and the sell side firm executing it for them. This in turn was very helpful in the communication of another of our recommendations, which garnered quite a lot of attention, namely that fixing transactions should be charged for. Previously, transactions were often executed for free, at least notionally. The “free” cost of the transaction probably increased the incentive for manipulation as trading desks sought to generate greater profitability to compensate for taking on this risk. The widening of the window in February served as a focal point for sell side firms to start charging for these services. Most sell side respondents to the FXCs’ surveys report that they are now charging for fixing transactions, particularly those linked to the London 4pm fixes and especially the most liquid currency pairs. That said, some respondents, who tended to be smaller banks less active in the fix, reported they were still reviewing their pricing structure for benchmark orders. Moreover, while there had been good progress in terms of the London fix, there was much less progress for other fixes. However, the scope for benchmark manipulation is there for all fixes, not just the London 4pm fixes, and hence it is important to reiterate that the recommendations of our report are intended to apply to all FX benchmarks. So how are fixes being charged for? A mix of pricing strategies is being used. Some are applying a bid-offer spread, some a fixed fee, where the fee is based on an assessment of the risk transfer involved. Others are pursuing a strategy which could be called “rent my algo”, where a firm provides access for a fee to an algorithmic trading tool to directly execute their fixing transaction in the fixing window. This in turn, leads me to another of the recommendations of the report, namely that banks should establish separate processes for handling and executing their fixing orders from other orders. This recommendation was designed to address potential conflicts of interest arising from managing customer flow. A sizeable number of banks have implemented this recommendation by shifting the execution of fixing orders from the spot voice FX trading desk to electronic trading desks that execute them with algorithms. The progress report is available at http://www.financialstabilityboard.org/wp-content/uploads/FX-Benchmarksprogress-report.pdf. BIS central bankers’ speeches As a result, the share of fixing orders executed by algorithm has increased substantially, as we document in the progress report. There is also considerably enhanced internal scrutiny from senior management around fixing transactions. Some firms have physically separated their fixing desk from other desks. This segregation of trading functions has involved some cost. Other participants regarded the cost of implementing this recommendation as being too high, given the size of their business, and have not implemented it to date. Others have decided to cease offering this service directly, in some cases offering customers a portal to other fixing services instead. Again, I would like to emphasise that the intention of our recommendations was that it was to apply to all participants, with appropriate consideration to the size and structure of the market. In the case of smaller, less actively traded currencies, separation of business is clearly more complicated than for large actively traded currencies, but in these cases participants should still be able to demonstrate to their customers that appropriate processes are in place, in keeping with the fundamental motivation of the recommendation to reduce the scope for benchmark manipulation. In terms of market conduct, we made a number of recommendations around appropriate sharing of information, including around trading positions (beyond that necessary for a transaction) and particularly customer information. As Roberto talked about earlier, these were picked up in a statement of Shared Global Principles that was published following the Global FXC meeting in Tokyo earlier this year.6 Many market participants have reflected these principles in their internal policies and codes of conduct, as well as revised policies around benchmark execution consistent with our recommendations. FX code of conduct More broadly in terms of improving market conduct, in May this year, the BIS Governors commissioned a working group of the Markets Committee of the BIS to facilitate the establishment of a single global code of conduct for the FX market and to come up with mechanisms to promote greater adherence to the code.7 There are two important points I want to highlight: first, it’s a single code for the whole industry and second, it’s a global code. It’s intended to cover the whole gamut of the industry. This is not a code of conduct for the sell side. It is there for the sell side, the buy side, non-bank participants, the platforms; its breadth is both across the globe and across the whole structure of the industry. I am chairing this work, with Simon Potter of the New York Fed leading the work on developing the code and Chris Salmon of the Bank of England leading the adherence work. Our group comprises representatives of the central banks of all the major FX centres.8 To repeat, it is very much a global effort reflecting the global nature of the foreign exchange market. This work is also very much a public sector-private sector partnership. In that regard, we are being supported in this work by a group of market participants, chaired by David Puth of CLS. The group contains people from all around the world on both the buy side, including corporates, and the sell side, along with trading platforms and non-bank participants, drawing from the various FXCs and beyond. Hence all parts of the market are being involved in the drafting of the code to make sure all perspectives are heard and appropriately reflected. These principles are available at: http://www.rba.gov.au/afxc/about-us/pdf/global-preamble.pdf. <http://www.bis.org/press/p150511.htm> <http://www.bis.org/about/factmktc/fxwg.htm> BIS central bankers’ speeches The work in drafting the text of the code is well and truly underway. There are two aspects to this. First is harmonisation of the existing regional codes. There is a lot of good material in them and there is no point in reinventing the wheel there. The second part of the work addresses those aspects of the foreign exchange market not adequately covered in the existing codes. We need to fill those gaps; for instance, in providing more detail around various aspects of order-handling and execution. We are also addressing mark-up and last look. We are aiming to provide language around what it means to participate in the market as principal rather than agent. In these areas we intend to describe what is good practice as well as what is not good practice. While the content of these regional codes is pretty good, it is very evident that they were often ignored, wilfully or otherwise. Hence the critical need to come up with mechanisms to achieve greater attention and adherence to the global code. We will have more to say on this later as our work in this area proceeds. At this stage, it is worth reiterating a point I made at an FX Week Conference in Sydney earlier this year in the context of the FX benchmark work:9 “if these recommendations were not acted on, authorities could conclude that a regulatory response was necessary to generate the desired improvement in market structure and conduct.” Mark Carney made a similar point in his Mansion House speech in June,10 as did Simon Potter in July.11 I think the message should be pretty obvious. This process of establishing a global code of conduct for the FX market provides an opportunity for the industry to work with the public sector to improve the FX market and restore confidence in it, rather than having a (possibly sub-optimal) solution imposed on it. That said, an overall aim of the code is for it to be principles-based rather than rules-based. There are a number of reasons why we intending to proceed in this manner, but from my point of view, an important reason is that the more prescriptive it becomes the easier it is to get around. Rules are easier to arbitrage than principles. If it’s not expressly prohibited or explicitly discouraged, then it must be ok seems to be the historical experience. The more prescriptive and the more precise the code is, the less people will think about what they are doing. If it’s principles-based and less prescriptive, then market participants will have to think about whether their actions are consistent with the principles of the code. The intention is to have this work of developing a single code to replace the various regional industry codes completed by May 2017, with a new framework for adherence completed at the same time. However, we intend to put out some parts of the global code, including drafts of material on order handling and execution, by May 2016. We recognise that there is a need for greater clarity around some of these issues sooner rather later. We will be providing this draft material to the various FXCs and other market participants for their input in the first quarter of next year. At the end of the process, for the code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed by the FXCs and market participants more generally. That said, the process does not really end, because as the foreign exchange market continues to evolve, the code will need to evolve with it. “FX Benchmarks”, Address to the FX Week Australia Conference, Sydney, 12 February 2015. Carney, M, “Building real markets for the good of the people”, Mansion House speech, 10 June 2015. Available at <http://www.bankofengland.co.uk/publications/Documents/speeches/2015/speech821.pdf>. Potter, S. “Trends in Foreign Exchange Markets and the Challenges Ahead”, Remarks at the 2015 FX Week Conference, New York City, 14 July 2015. Available at <https://www.newyorkfed.org/newsevents/speeches/2015/pot150714>. BIS central bankers’ speeches Conclusion As market participants, regardless of which side of the market you are on, it is important that you are aware of the changes that have occurred, and are still underway, in the foreign exchange market. If you are on the sell side, I am sure that you are well aware of these changes and hopefully, I have provided you with some of the background and motivation for them. In terms of benchmarks, there is a fuller articulation of this in the FSB benchmark report. If you are in the asset management business, you may not have paid so much attention to the details of the FX aspect of your business. But it is important that you also understand the context for the changes that are occurring. Some practices and services that you were accustomed to in the past, or maybe were unaware of, may no longer be available, and you cannot expect your counterparty to provide them. The motivation for the changes to the foreign exchange benchmarks is to reduce the incentive and opportunity for improper behaviour by market participants around benchmark fixes. The implementation of the recommendations in the FSB benchmark report, together with the enhanced scrutiny externally and within organisations on fixing transactions, appears to have moved the market in a favourable direction. As we develop the single code of conduct for the FX market, the intention is that the market will move further to a more favourable and desirable location and allow participants to have much greater confidence that the market is functioning appropriately. We need this to occur, as it very much in all our interests to have a well-functioning foreign exchange market. As Roberto said earlier, we central banks care as much about this as anyone. As it is in all our interests for trust to be restored to the FX market, I very much trust that you, as market participants, will work with us constructively in this important endeavour. BIS central bankers’ speeches | reserve bank of australia | 2,015 | 12 |
Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 12 February 2016. | Glenn Stevens: Summary of economic developments during 2015 and outlook for Australia Opening statement by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 12 February 2016. * * * Chair Members of the Committee Since the Committee’s previous meeting in September, we have continued to see evidence that economic activity outside the resources sector has been gradually improving. The pattern observed six months ago whereby business surveys were suggesting improving conditions by and large continued through to the end of the year. Inevitably, this expansion is not uniform across the country or across industries. Areas that led the growth dynamic a few years ago are on the trailing edge now. Conversely, some that were subdued for a few years are among those leading growth today. But few, if any, expansions are completely even, either geographically or by industry. Given the nature of the economic events through which we have been living, moreover, it is not surprising that there are differences. The good thing is that there are strong areas to counteract the weak ones. The available information suggests that real GDP is expanding at pace a bit lower than what we used to think of as normal. Our estimate is that growth over the four quarters of 2015 was about 2½ per cent. This continued expansion has occurred in the face of a very large contraction in capital spending in the mining sector, restrained public final spending and the reduction in national income coming from the declining terms of trade. It has been helped by easy monetary policy and the lower exchange rate. Notwithstanding below-average GDP growth, the demand for labour increased at an above average pace in 2015. The number of people employed, as measured, increased by well over 2 per cent, participation in the labour force picked up and the rate of unemployment declined, to be below 6 per cent. That is a noticeably better outcome than we expected a year ago. This poses the obvious question of how, with apparently still somewhat below-trend GDP growth, the rate of unemployment has fallen. And whether the pattern will continue. Of course, it may be that the labour force data overstate the strength. Alternatively they may be telling us something not yet apparent in the GDP estimates. More data may shed light on this question over time. Part of the reconciliation appears to be that growth has been concentrated somewhat in labour-intensive areas, like certain household and business services. Another part of the reconciliation probably lies in the very modest pace of growth of labour costs. At any given rate of unemployment, wages growth appears to have been lower than would have been expected based on historical relationships. In fact, at an economy-wide level, unit labour costs – that is, wages per unit of aggregate output – have not risen for four years. This has surely helped employment. This same phenomenon is also important in understanding the behaviour of inflation, which has been quite low. As measured by the Consumer Price Index, inflation was 1.7 per cent over 2015. This was affected by falling prices for petrol and utilities, the latter in part due to government policy decisions. But even the underlying measures, which remove or down-weight such effects, at around 2 per cent, are low. Price rises for non-tradeable items BIS central bankers’ speeches are at their lowest for many years, and this reflects, among other things, the modest growth of labour costs. In summary then, the economy is continuing to grow at a modest pace, in the face of considerable adjustment challenges. It has apparently been generating more employment growth and lower unemployment than we expected, while inflation has remained quite low. Turning then to the rest of the world, there have been some key developments since we last met with the Committee. In December, the United States Federal Reserve raised its policy interest rate for the first time in 9½ years. The last time the Fed actually started an upward phase in rates was as far back as 2004. The Fed’s rationale for this change was that the US economy had sufficient strength that a zero interest rate was no longer needed – and, as such, it is a welcome development. The change had been very well telegraphed and was absorbed by financial markets without any immediate disruption. That said, US dollar funding costs are important to many financial strategies around the world and when they start to increase, however gradually, investors adjust their positions. This had already been happening in anticipation of the Fed’s decision, with funds seeking to lessen their exposures to emerging markets, high-yield debt instruments and so on. These adjustments continued subsequent to the Fed announcement. For some emerging market economies, facing lower commodity export prices, things have become more challenging. At the same time, some other major jurisdictions have sought to ease their monetary policies further. Both the European Central Bank and the Bank of Japan have pushed rates on some deposits at the central bank below zero. In other words, policy trajectories among the major jurisdictions are diverging, which creates the potential for market movements, not least in exchange rates. Meanwhile, the Chinese economy has become more of a concern for many observers. It is not that the actual data on the Chinese economy are all that different from what we had been seeing. They paint a picture of softness in growth – but they were already saying that some time ago. The more recent anxiety is probably best described as greater uncertainty over the intentions of Chinese policymakers and over whether they will be able to carry off the economic transition China needs. This anxiety has been reflected in capital flows. Commodity prices have generally fallen further over recent months. Most prominent was the further fall in crude oil prices to about US$30 per barrel. While this level of oil prices is not especially low in a longer-run historical context, it is a large decline from prices prevailing in recent years and is bringing considerable adjustment. Oil-producing companies and nations are seeing a decline in their incomes, and yields on debt issued by corporates in the energy sector have increased sharply. Exploration expenditure and investment in new capacity is being rapidly curtailed. Sovereign asset managers for some key oil producers are liquidating some assets to help manage the effects on fiscal positions. As with most price changes, there are gainers as well as losers. The fall in energy costs is a windfall to energy users and represents a terms of trade gain for countries that are net importers. Importantly, it does not appear to be the case that the fall has predominantly been caused by weak demand for oil. Indications are that oil demand has still been rising, albeit not as quickly as it had been. Supply increases appear to have been more important than demand factors in explaining the large price fall, at least thus far. Hence, we should not interpret the decline in oil prices as uniformly negative. On the contrary, a fall in oil prices resulting from additional supply has usually been seen clearly as a bonus for consumers and many businesses in advanced economies, including Australia. In financial markets, as investors and traders have sought to make sense of all these conflicting currents, we have seen a period of volatility recently. This has been apparent in BIS central bankers’ speeches equity and bond markets, as well as foreign exchange markets. Equity markets are lower, yields for core sovereign obligations are lower, spreads for lower-rated corporates and emerging market sovereigns are wider. Exchange rates have seen more variability, with currencies for many emerging market countries weaker. The Australian dollar is around the same level now as when we last met with the Committee, though commodity prices are lower. Looking ahead, forecasters expect a bit less growth in the global economy this year than they did a few months ago. Expectations for Australia’s trading partner group itself are for growth to be a bit below average, little changed from six months ago. Inflationary pressures globally look quite subdued. Global interest rates will still be very low, even if short-term rates move up a bit further in the United States. For Australia, the adjustment we have been experiencing for a couple of years now will most likely continue. The terms of trade are still falling. The fall in mining investment spending will continue for at least one more year, though it is probably having its most significant effect on the rate of growth now. Other areas of demand are expected to add to growth. The net effect of all this is likely to be continuing expansion at a moderate pace. One key question will be whether the recent financial turbulence itself will have a material negative effect on aggregate demand – in Australia or abroad. I don’t expect that we will be able to answer that question for a little while yet. Another question is what the recent unexpected strength in the labour market means for the outlook. If it turns out that the strength is just temporary, then the outlook is still for moderate growth, but no near-term acceleration. If, on the other hand, recent trends were to continue, the income gains coming from higher employment may start to feed into stronger demand growth, which would probably lead in due course to higher levels of investment. Alternatively, if demand growth were to be in areas that require relatively little capital to support the labour employed, then the apparent weakness in capital spending outside mining could be of less concern anyway. As usual, there are many questions regarding both our current circumstances and the outlook. At its recent meetings, the Reserve Bank Board has kept the stance of policy unchanged, with the cash rate at 2.0 per cent. We will be examining new information over the months ahead as we try to discern the answers to these and other questions. With inflation unlikely to cause a problem by being too high over the next year or two, the statement after the recent meeting indicated that the Board retains the flexibility to ease further, should that be helpful. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 2 |
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Australian Shareholders Association (ASA) Investor Forum, Sydney, 18 February 2016. | Malcolm Edey: The evolving risk environment Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Australian Shareholders Association (ASA) Investor Forum, Sydney, 18 February 2016. * * * This is an expanded and updated version of a speech presented in November 2015. Malcom E (2015), “The Risk Environment and the Property Sector”, speech at the Australian Property Institute’s Queensland Property Conference, Gold Coast, 6 November. Thanks for the opportunity to speak to you today. I have taken as my subject “the evolving risk environment”. As you know, the Reserve Bank has a longstanding mandate to promote financial stability. The way we interpret that mandate, its place in the wider central banking framework, and its interaction with the mandates of the other financial regulators, are large topics in themselves. 1 For today, I simply note that one of the ways we seek to promote financial stability is by providing regular analysis of system risks, particularly through our half-yearly Financial Stability Review. We do that partly to inform the policy debate, but also because it is important that lenders and investors are well informed about the risk environment, so that they can make prudent decisions about the risks they choose to accept. As investors in the share market, you will be well aware that investment is a risky activity. In the early part of this year we have seen some significant falls in equity prices and higher volatility in equity markets around the world. There has been significant volatility in other markets too, notably including large falls in oil prices. There is no shortage of commentators offering interpretations of these events and predictions of what might follow. I am not going to be offering those sorts of predictions today. Instead, I think the way I can best contribute to your thinking about these things is to place them in the wider context of the evolving financial risk environment over the past few years. The post crisis environment In many ways the current situation continues to be shaped by the aftermath of the global financial crisis (GFC). The epicentre of the crisis is usually dated to the collapse of Lehman Brothers in September 2008, and the general recovery that we have had since then began about six months later. On that basis, we have been in a period of global economic recovery now coming up to about seven years. In broad outline, this has been a period marked by: • A return to reasonably solid growth in world GDP, at rates either around trend or not much less than that. • Widespread, though somewhat varied, progress in balance sheet repair in banking institutions; and • Generally improved conditions in financial markets. These have all been positive developments: they represent a substantial cumulative improvement since the height of the crisis, and it is important to keep that perspective when interpreting shorter-term fluctuations in market sentiment. I discussed some of these issues in an earlier speech. Malcolm E (2013), “The Financial Stability Role of Central Banks”, speech at the Thomson Reuters’ Australian Regulatory Summit, Sydney, 1 May. BIS central bankers’ speeches That said, there are a number of qualifications that should be made to the summary picture I have just given: • Growth around the world during this period has been uneven geographically. China and other emerging market economies initially led the recovery while Europe tended to lag. More recently this configuration has been changing, with Asian growth softening and Europe looking firmer. The US has achieved fairly steady growth throughout the period. • Labour market slack remains in some areas of the global economy, especially in parts of Europe. • Global debt levels remain high. • And the recovery has been marked by periodic bouts of nervousness in financial markets, including the one we are seeing just now. I will have more to say about that later. One general indicator that things are still some way short of normality is the level of global interest rates, which are still at exceptionally low levels to support growth. This remains the case notwithstanding the much-heralded rise in the US Federal funds rate at the end of last year. An obvious question that arises from all of this is why has the recovery from the deep recession of 2008 and 2009 been so protracted? I suggest that there are two important factors at work here. The first factor is that the GFC period involved more than one crisis. It began in the US mortgage market in 2007 and spread through various channels of contagion to banks and financial institutions in other parts of the world, especially the euro area and the UK. That was the initial crisis, triggered by poor asset quality and excessive leverage. But even as the US was recovering from that, a second crisis was developing in Europe. This was a crisis of confidence in the sustainability of the euro as a single currency area. At different times a number of the weaker economies in the area have come under scrutiny as to whether they would be able to meet their obligations, with concerns particularly focused on Greece in key periods. These episodes led to strains in financial markets and increases in risk pricing, and they weighed heavily on confidence and on the pace of recovery. With the euro area accounting for just under one sixth of the global economy, this in turn acted as a significant drag on global growth. The second factor is that, other things equal, history suggests that recoveries from financial crises typically take longer than those from other types of business cycle events. It takes time to repair balance sheets, to reduce excessive leverage and to unwind the asset market imbalances that might be left behind by a crisis; and it takes time to reverse the damage to trust and confidence. One important recent study 2 found that the average duration of impact from financial crises across a range of countries over the past two centuries has been around five years. Since this current episode has been more severe than most, it is not surprising that its after-effects have lasted even longer. An exacerbating factor, too, has been the international dimension. When a financial or a banking crisis occurs in a single economy, or in a relatively small number of countries, exchange rate depreciation is often part of the market response and part of the recovery mechanism. But there is obviously much less scope for that mechanism to work when a crisis affects large parts of the global economy simultaneously. Reinhart CM and K Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, Princeton. BIS central bankers’ speeches Taken together I think these factors go a long way towards explaining the drawn-out nature of the global recovery to date – even though, as I said, economic conditions in recent times have been much better than they were a few years ago. Policymakers around the world have been responding to this situation on a number of fronts. Interest rates were reduced to near zero (or even slightly below zero) in many advanced economies to support recovery and assist in balance sheet repair, and they remain very low. In Europe, significant institutional reforms are being made to strengthen the stability of the euro area; these are aimed at getting banking and crisis-management arrangements across the area to function in a more unified way that makes them more robust to shocks in the future. And globally, there is an extensive program of reform underway, for example in banking and securities regulation, to build resilience in our financial systems. Australia has been very much a part of that process. A related development in this period is that there has been a renewed interest in more proactive approaches to the management of systemic risk. Partly this reflected the lesson from the GFC itself that financial crises are costly, and hence that there is a strong need for better risk management. In keeping with that, institutional arrangements have been strengthened in some jurisdictions to support more proactive risk management by supervisors, where that was found to be lacking. A related point is that, in a low interest rate environment, supervisors have seen a need to be particularly vigilant against a build-up of risk in interest-sensitive sectors. A number of them have been taking measures in recent times to respond to developing risks, often focused on property lending. I will have more to say about that later. To summarise (and oversimplify) this picture somewhat, the after-effects of the GFC on the global economy have included: • an extended period of low interest rates • “search for yield” behaviour by investors in some interest-sensitive sectors, and • a strengthened focus on risk management by prudential supervisors. Recent developments With all of that as background, I want to turn now to more recent developments. It is useful to take that in three parts, namely the global risk environment, possible implications of that environment for Australia, and domestically generated sources of risk. The global risk environment Prior to the current bout of market volatility, our most recent Financial Stability Review, published late last year, noted an improvement in conditions in Europe and a general shift in the focus of risk towards emerging economies. In Europe this trend seemed to reflect, at least in part, a greater degree of confidence in Europe-wide institutions. The European authorities have taken a number of actions over recent years to alleviate financial system risks, including increased support from the ECB and ongoing progress in unifying the system of banking regulation. More generally, the condition of the European financial sector has been gradually improving in a number of respects. Non-performing loans of European banks are still high, but they have been falling for two years mainly in some of the periphery countries (Graph 1). Bank profitability has picked up a bit and banks are now better capitalised. And stronger balance sheets have enabled banks in the euro area to make some gradual increases in their lending to businesses and households. All of that said, there remain significant uncertainties in the euro area and some of the earlier concerns have resurfaced in the recent market turmoil. BIS central bankers’ speeches Graph 1 At the same time, our Review noted that financial stability risks in China have been building. The Chinese economic expansion over recent years has been associated with increasing debt, strong asset price growth and apparent overinvestment in some sectors and regions (Graph 2). If growth were to fall further from its high recent rates, past excesses might be exposed, and leverage is always harder to manage in a slower growth environment. These risks of course are hard to assess. The Chinese authorities have many levers to support growth and financial stability, given the ongoing large role of the state in the economy, the heavily regulated financial system and the presence of capital account controls. The measured central government fiscal position is also strong, though the overall public sector position is less so given the build-up in debt among local governments and state-owned enterprises. BIS central bankers’ speeches Graph 2 Outside China, country-specific risks also seem to have been increasing in a number of other emerging market economies – for example Brazil, Russia and Turkey. Among the various factors contributing to that have been falling commodity prices, political instability and concerns over excessive corporate leverage. In response, equity prices and exchange rates in these economies have generally fallen quite sharply. These trends were already evident through the course of last year. These factors form part of the background to the nervousness seen in a number of markets in the early part of 2016. As I said at the outset, the early part of this year has seen some significant volatility in global markets, especially in equities and in some commodity prices. There has also been some widening in risk spreads for lower rated corporates and emerging market sovereigns. The broad equity price indices have fallen by around 10 per cent in the United States, 15 per cent in Europe, and by around 20 per cent in China since the start of the year (Graph 3). These have been accompanied by further large falls in prices of some commodities, most notably oil, continuing the declines that they had recorded over the previous couple of years (Graph 4). BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches From a financial stability perspective, these developments raise a number of important questions: to what extent (if any) are these price movements inter-related, and in what way? And what, if anything, do they tell us about the evolving risk environment? It is in the nature of these things that definitive interpretations are rarely possible, and certainly not in real time. At this stage a number of possible hypotheses might be put forward: • the combination of lower equity and commodity prices might be signaling a weaker global outlook; • it might simply be an indication that equity markets had previously been overvalued and in need of a correction; or • the equity price falls might in part be an irrational response to commodity price falls and other economic data, or at least contain an element of overreaction to genuine signals. Most likely there is an element of validity in more than one of these, and no doubt other hypotheses can be put forward as well. As I said, I don’t think it is possible to be definitive about these things, but it is relevant to note that market and media commentary often errs on the side of being unjustifiably gloomy. A few points can be made on that score: • First, as always, the recent equity price movements have to be put in perspective. This is not the first bout of nervousness in these markets: in the advanced economies there was a similar one late last year, from which markets subsequently recovered, and the recent declines reverse only a small part of the cumulative gains during the post-crisis recovery period. • Second, there seems to have been relatively little new economic data in the early part of this year to trigger a significant reassessment of the global outlook. And even though the Chinese economy has been slowing, it is still growing at a reasonable rate. • Third, the hypothesis that falling equity and falling oil prices are inter-related responses to a weakening in global demand is hard to sustain. The falls in oil prices seem to be mainly driven by strong supply, not weak demand, as indeed has been the case for a number of other commodities such as iron ore. Consistent with that, other non-energy commodity prices have been relatively stable during this recent period when oil prices have continued to fall. This has important implications for the general outlook. While an oil supply expansion could be expected to have a range of complicated effects on producers, consumers and holders of energy assets, it would normally be considered a net positive for the world as a whole. I think these points argue against putting an excessive focus on recent market movements. But, that said, there has clearly been an increase in market volatility around the word in recent times and a heightened focus on financial risks. Implications of the global risk environment for Australia At this point it is useful to ask how these international sources of risk might affect the Australian financial system. Direct exposures of Australian banking institutions to the risk factors I have been describing are quite limited (Table 1). Exposures to the euro area have been scaled back in the wake of the crisis and now represent only around 1 to 2 per cent of Australian banks’ consolidated global assets. Although exposures to the Asian region have been growing quite rapidly over recent years, they are still a relatively small share of consolidated assets – around 4 per cent. Many of these exposures are shorter-term and trade-related, factors that should lessen BIS central bankers’ speeches credit and funding risks. That said, operational and legal risks around these exposures could be relatively high, particularly given the rapid expansion of these activities in recent times. Table 1 Australian Banks’ International Exposures Ultimate risk basis, September 2015 Value Share of international exposures Share of global consolidated assets $ billion Per cent Per cent New Zealand Asia(a) – China United Kingdom United States Europe – Greece Other Total (a) Asia includes offshore centres Hong Kong and Singapore. Sources: APRA; RBA. As a more general observation, Australian banks have increased their resilience over recent years in a number of respects, responding both to market expectations and to regulatory and supervisory actions. Notably they have raised capital ratios and shifted their funding structures to make them more resilient to financial market disruptions. Of course, none of this guarantees that Australian banks will be immune to international shocks in the future. But it suggests that the main effects from the risks I’ve been describing are likely to be indirect, working through the impact of factors like commodity prices, trade flows, and confidence, on the broader economy. Domestically generated sources of risk That brings me to the third part of our risk assessment, namely domestically generated sources of risk. Here our analysis has for some time focused on the buoyancy seen in parts of the property market and the leverage associated with that. Much of the focus has been on residential property, and I will start with that before turning to the commercial sector, where risks have also been growing. While the housing market has not been universally strong around the country, we have seen a period of significant strength in the Sydney and Melbourne markets in recent times, with investors playing a large role. We are now seeing some easing in these pressures, as I will describe in a moment. But to summarise a few of the key facts: BIS central bankers’ speeches • Housing prices in Sydney reached a peak annual rate of increase of 18 per cent in mid-2015. • In Melbourne the peak rate of increase was 14 per cent around the same time. • The value of loan approvals to investors in New South Wales approximately doubled over the two years to mid-2015. Largely as a result of these developments, the household debt ratio has been edging up again from a level that was already high, at around 1½ times annual income (Graph 5). Graph 5 It is against this background that the Reserve Bank has highlighted the need for prudence, and has supported APRA and ASIC in the various measures that they have taken over the past few years to strengthen lending standards. As a general proposition, mortgage lending standards in the post-crisis period have been tighter, at least more so than before the crisis. Low-doc loans are rare, genuine savings are required to fund at least part of the deposit, and the application of interest rate buffers in serviceability assessments has become widespread. Nonetheless, investigations by APRA and ASIC during 2015 showed that there had been some slipping in lending standards and that they were inadequate in some important respects to the current risk environment. Specifically, APRA found that, in some instances, lenders’ serviceability assessments were based on over-optimistic judgments about the reliability of borrowers’ incomes, or inadequate estimates of borrowers’ living expenses, or that they failed to take into account the possible effect of future interest rate movements on a borrower’s existing debt commitments. ASIC’s review of interest-only lending practices made similar findings, and also noted instances where the lender did not make reasonable inquiries as to whether the loan product provided was suitable to the borrowers’ circumstances. BIS central bankers’ speeches Furthermore, as a result of the additional scrutiny over the past year and substantial data revisions made by the banks, we now know that the level of investor activity in the housing market was in fact higher than previously thought. As we have highlighted in recent Reviews, a high level of investor activity can add to the level of financial risks associated with residential markets. As you know, APRA announced a number of supervisory measures in December 2014 to strengthen mortgage lending standards. These measures included expectations that: • banks should not be increasing their share of higher risk lending • growth in investor lending should not be materially above 10 per cent • appropriate interest rate floors and buffers should be applied in serviceability assessments. In response, lending standards tightened significantly over 2015. Interest rate buffers and floors were increased at many banks and they are now much more uniform across the sector. The level of higher risk lending has declined, notably lending with an LVR greater than 90 per cent. And the pace of investor lending growth has slowed significantly in response to a wide range of price and non-price actions that have been taken by the banks (Graph 6). This has been a welcome development given the general maturing of the current housing cycle. Graph 6 The second main area of risk focus domestically has been in commercial property. Historically this sector has been a common source of financial instability both here and abroad. During the height of the GFC, Australian banks remained in comparatively good shape but they did suffer a noticeable deterioration in asset performance, with the aggregate non-performance rate rising to just under 2 per cent of loans. A significant part of that deterioration was in their commercial property lending; impaired commercial property BIS central bankers’ speeches exposures accounted for around 30 per cent of Australian banks’ non-performing domestic assets at that time. After the post-crisis downturn, the commercial property sector is again experiencing strong investor demand, and bank lending to the sector is increasing. However, there are a number of emerging signs of increasing risk. Trends in commercial property prices and rents have been diverging over the past few years, with prices continuing to rise while rents have been flat to down (Graph 7). As a result, yields have declined. At the same time, vacancy rates have been increasing. Graph 7 As in the housing market, conditions have not been uniform across the country, and they have been noticeably firmer in Sydney and Melbourne than in other cities. But the major commercial property markets have all seen downward pressure on yields over recent years. Strong demand from foreign buyers has contributed to this, reflecting the global environment of low interest rates and “search for yield”. The risks appear manageable at this stage, but they underscore the need for sound lending practices and for appropriate prudence by investors. Concluding comments In summing up, and to return to my original theme, the Reserve Bank has a longstanding mandate for financial stability, affirmed for example as part of the Wallis reforms in 1998. In the post-Wallis world, this has not been primarily a regulatory function. The Bank does have regulatory powers in some areas relating to financial stability, notably in its oversight of payments systems and financial market infrastructures. But the financial stability function goes well beyond that to the Reserve Bank’s wider role in the financial system. It includes the BIS central bankers’ speeches Bank’s role as the liquidity manager for the system and as the provider and operator of core payments infrastructure. It also includes coordination with other regulators. At a formal level, this is done through the Bank’s role in chairing the Council of Financial Regulators, but there are numerous less formal channels of coordination and sharing of information and analysis. These arrangements were reviewed and supported most recently in the Murray Inquiry. One important component of this financial stability work is the provision of timely risk analysis, to help inform the policy debate and also to help inform the decisions of lenders and investors. I have given a summary of our latest analysis today, and I hope you will find that helpful in informing your own investment decisions. With that, I thank you for your attention, and wish you every success. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 2 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the KangaNews Debt Capital Markets Summit 2016, Sydney, 22 February 2016. | Guy Debelle: Interest rate benchmarks Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the KangaNews Debt Capital Markets Summit 2016, Sydney, 22 February 2016. * * * I would like to thank Ellis Connolly for assistance in the preparation of these remarks. Today I am going to talk again about interest rate benchmarks, as there have been some important recent developments. 1 These benchmarks are very much at the heart of the plumbing of the financial system. They are widely referenced in financial contracts. For example, the interest rate on a corporate loan is often a spread to an interest rate benchmark. Many classes of derivative contracts generally are based on them, as are most asset-backed securities. In light of the issues around London Inter-Bank Offered Rate (LIBOR) and other interest rate benchmarks, there has been a global reform effort under the aegis of the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) to improve the functioning of interest rate benchmarks. 2 I will focus on domestic reforms around the principal interest rate benchmark in Australia, the bank bill swap rate (BBSW). I will also mention plans underway to introduce a “risk-free” interest rate for the domestic market, as a complement to BBSW. I will not talk about the investigations that ASIC is currently undertaking into conduct around BBSW. Reforms to the BBSW methodology As you may be aware, in recent months, the Council of Financial Regulators (CFR) has been conducting a consultation on possible reforms to the BBSW methodology. 3 I will run through the motivation for doing so, outline the key issues that have been raised in the consultation, and put forward some proposed reforms for market participants to consider. Given its wide usage, BBSW has been identified by ASIC as a financial benchmark of systemic importance in our market. 4 It is important there is ongoing confidence in it. Without that, we have a serious problem, given its integral role in the infrastructure of domestic financial markets. As you may know, BBSW was calculated for a number of years by, each day, asking a panel of banks to submit their assessment of where the market was trading in Prime Bank paper at a particular time of the day. While it was a calculation based on submissions, it differed from LIBOR in that BBSW submitters were asked about where the market for generic Prime Bank paper was trading that day. In contrast, LIBOR submitters were asked about where they thought their own bank’s cost of funds was that day. Debelle G (2015), ‘Benchmarks’, Address to Bloomberg Summit, Sydney, 18 November. See Financial Stability Board (2014), ‘Reforming Major Interest Rate Benchmarks’, July, available at <http://www.financialstabilityboard.org/wp-content/uploads/r_140722.pdf>; and Financial Stability Board (2015), ‘Progress in Reforming Major Interest Rate Benchmarks’, Interim Report on Implementation of July FSB Recommendations, July. Available at <http://www.financialstabilityboard.org/wpcontent/uploads/OSSG-interest-rate-benchmarks-progress-report-July-2015.pdf>. See Council of Financial Regulators (2015), ‘The Evolution of the BBSW Methodology’, Consultation Paper, October. Available at <http://www.cfr.gov.au/publications/consultations/evolution-of-the-bbsw-methodology/>. See Australian Securities & Investments Commission (2015), ‘Report 440 Financial benchmarks’, July. Available at <http://download.asic.gov.au/media/3285136/rep440-published-8-july-2015.pdf>. BIS central bankers’ speeches In response to the prospect of a large number of the participants on the submission panel no longer being willing to provide submissions, the calculation of BBSW was reformed in 2013 in line with the IOSCO Principles for Financial Benchmarks, which were issued in July 2013. 5 Since 2013, the Australian Financial Markets Association (AFMA) has calculated BBSW benchmark rates as the midpoint of the (nationally) observed best bid and best offer (NBBO) for Prime Bank Eligible Securities, which are bank accepted bills and negotiable certificates of deposit (NCDs). Currently, the Prime Banks are the four major Australian banks. The rate set process uses live and executable bid and offer prices sourced from interbank trading platforms approved by AFMA, These platforms are currently ICAP, Tullett Prebon and Yieldbroker. The bids and offers are sourced at three points in time around 10.00 am each day. While the outstanding stock of bills and NCDs issued by the Prime Banks has increased since 2013 to around $140 billion (Graph 1), trading activity during the daily BBSW rate set has declined over recent years to very low levels (Graphs 2 and 3). There are quite a number of days where there is no turnover at all at the rate set. The low turnover in the interbank market raises the risk that market participants may at some point be less willing to use BBSW as a benchmark. This is the motivation for the CFR’s consultation to ensure that BBSW remains a trusted, reliable and robust financial benchmark. Graph 1 See International Organization of Securities Commissions (2013), ‘Principles for Financial Benchmarks’, Final Report, July. Available at <https://www.iosco.org/library/pubdocs/pdf/IOSCOPD415.pdf>. AFMA’s assessment of its processes against these principles can be found at <http://www.afma.com.au/data/iosco-principles>. BIS central bankers’ speeches Graph 2 Graph 3 There is considerably more activity in the NCD market than is being measured at the rate set, with the activity mainly occurring outside the interbank market. Given the size of the market and the short maturity of the securities, on average over $1 billion in NCDs are issued each day. Some preliminary data collected from the four major Australian banks indicate that BIS central bankers’ speeches this issuance is regular, with at least $100 million in NCDs bought or sold on almost all business days at the one, three and six-month tenors. However, the non-bank participants that buy and sell NCDs tend to transact bilaterally with the issuing bank, with the price struck at the (yet to be determined) BBSW rate, rather than at a directly negotiated rate. If these participants could be encouraged to buy and sell NCDs at outright yields, then these transactions would have the potential to make the BBSW benchmark more robust. Consistent with there being a shift in NCD trading activity to outside the interbank market, banks’ holdings of NCDs as a share of total issuance has declined over recent years to below 20 per cent (Graph 4). Over the same period, there has been a steady increase in holdings by super and other investment funds, with their share of NCD issuance rising to almost half recently. Graph 4 As part of the consultation, the CFR received 15 written submissions from a wide range of market participants, including the Prime Banks, NCD investors, and users of BBSW as a benchmark. We have also spoken directly with market participants to better understand what has caused the decline in trading activity during the rate set and to discuss potential solutions. To bring all this together, the CFR recently released a discussion paper for AFMA and market participants to consider, which summarises the views of market participants and proposes some improvements to the BBSW methodology. 6 Most market participants share our concern about the low trading volumes during the rate set and acknowledge that changes to the BBSW methodology will be necessary. But before making any changes, it is crucial to understand why so little trading has been occurring during the rate set. Four key reasons were put forward by market participants: See Council of Financial Regulators (2016), ‘The Evolution of the BBSW Methodology’, Discussion Paper, 9 February. Available at <http://www.cfr.gov.au/publications/consultations/evolution-of-the-bbswmethodology/discussion-paper.pdf>. BIS central bankers’ speeches • First, institutions face a potential conflict of interest when they participate in the market underpinning a benchmark as well as the derivatives market that references the benchmark. Many institutions state they are uncertain about how regulators expect these conflicts to be managed. As a result, they are reluctant to trade during the rate set. • Second, managers of money market funds are reluctant to trade at outright yields during the rate set. They prefer to agree the volume of their bill transactions with a Prime Bank before 10.00 am and set the rate after 10.00 am at BBSW, since this minimises their tracking error against their benchmark. • Third, investors subject to credit limits are reluctant to trade during the rate set where bills are traded as a homogeneous asset class, as they could be delivered the bills of a Prime Bank for which they have already used up their credit limit. • Finally, foreign bank branches have less demand for bank paper than in the past since it is not considered a high-quality liquid asset under the Liquidity Coverage Ratio either in Australia or in their home jurisdictions. Despite these challenges, it is crucial that BBSW remain a trusted, reliable and robust financial benchmark given its importance to the financial system. To ensure this, the CFR has put together a proposal for the evolution of the BBSW methodology, taking into account the feedback provided through the consultation process. In putting forward this proposal, the key objectives are to ensure that: • BBSW is anchored to observable arm’s length transactions in an active underlying market; • the BBSW calculation mechanism is robust to changing market conditions; • the fundamental properties of BBSW are maintained to ensure a seamless transition for financial contracts as the methodology evolves. While most participants are in favour of some changes to the methodology, there are many features of the existing methodology where there is consensus that they should be retained. In particular, there was broad support that the securities underlying BBSW continue to be the NCDs and bank bills of the Prime Banks, as they are relatively homogeneous and liquid. As a result, we don’t need to go down the path of calculating BBSW as a broader measure of banks’ short-term wholesale funding, as is being considered for LIBOR and Euro Interbank Offered Rate (EURIBOR). This avoids the risk of there being a significant change in the characteristics of BBSW which could lead to contract frustration. To boost activity during the rate set, most submissions supported broadening the definition of the underlying market beyond the interbank market to include transactions with a wider range of counterparties, such as investment funds and the treasury corporations. These submissions highlighted that there is much more activity in the market prior to the rate set than during the rate set. This activity prior to the rate set has the potential to underpin BBSW, assuming market participants agree to transact at directly negotiated rates rather than at BBSW. Given the much larger role that non-banks play in the market, we agree that it is time to widen the underlying market beyond the interbank market to include such counterparties. There is a risk that activity in the interbank market alone will not be sufficient to support the calculation of BBSW, and the credibility of the benchmark would be enhanced by the participation of counterparties that come from outside the banking sector. The key change to the methodology proposed by many of these submissions was to calculate BBSW directly from market transactions, rather than using the NBBO method. That is, calculating BBSW as the volume-weighted average price (VWAP) of market transactions during the rate set window. Given the objective is to better anchor BBSW to transactions in the underlying market, we support moving the calculation methodology to the VWAP. BIS central bankers’ speeches Calculating the VWAP should be feasible for the one, three and six-month BBSW tenors, since these are the most liquid. The Prime Banks issue three and six-month NCDs on almost a daily basis, and there is an active market in buying back one month NCDs. If there were to be insufficient transactions to calculate the VWAP at these tenors, NBBO was widely supported by market participants as an appropriate fall-back methodology. However, there is unlikely to be sufficient liquidity in the underlying market at the two, four and five-month tenors to reliably calculate the VWAP, so we propose that these tenors be calculated by interpolation from the more liquid tenors. While there was solid support for the VWAP methodology, there was a wide range of views as to how the transactions during the rate set should be executed. Three methods proposed were: 1. Direct negotiation between Prime Banks and investors, with issuance and secondary market transactions being negotiated and executed in terms of outright yields, most likely over the phone. A rate set window of around 60–90 minutes (for instance, from 8.30 am to 10.00 am) should provide sufficient time for such transactions to take place. 2. An electronic trading market, with transactions being executed on the trading platforms where the Prime Banks and investors post bids and offers in terms of outright yields for a particular Prime Bank’s NCDs. A rate set window of around 30–45 minutes (for instance, from 9.15 am to 10.00 am) should be sufficient. 3. A tender process, with the issuance and secondary trading of each Prime Bank’s NCDs taking place in terms of outright yields through an auction. Given that all the transactions would be executed at the same time, the rate set window could be quite short (for instance, bids and offers could be submitted over a 15-minute period, with the tender closing at 10.00 am). Each of these methods has its advantages and disadvantages. Conducting the transactions over the phone is flexible and is most similar to current market practice, so it would be unlikely to require extensive changes to systems and procedures. However, it would be the least transparent, which may discourage participation from investors and necessitate more oversight of the conduct of market participants. An electronic trading market would also be able to facilitate a wide range of transactions while significantly improving market transparency. However, the platforms currently only serve the inter-bank market, so other participants would need to change their systems and procedures. Finally, a tender would probably have the shortest rate set window, reducing basis risk for investors and minimising the length of time that the Prime Banks are required to make prices. However, the design of the tender would be quite complex to support a wide range of transactions such as switch trades (where, for instance, an investor simultaneously sells NCDs with a one-month tenor and purchases those with a six-month tenor). This may lead some market participants to be reluctant to participate. While none of these execution methods is clearly superior to the others in all dimensions, the market will need to eventually coalesce around one of them to maximise the amount of activity during the rate set. To me, the methods involving trading on electronic platforms are the most attractive, given the associated visibility and transparency that comes with trading across a platform. However, to ensure that BBSW remains robust in the near term, it may be necessary for market participants to continue transacting over the phone but at outright yields, and for the benchmark administrator to use these transactions to calculate the VWAP. Regardless of which method for executing the transactions is chosen, the key challenge is going to be to get investors to be more comfortable with transacting a significant share of their NCD transactions at directly negotiated rates. Maintaining BBSW as a robust benchmark is clearly in everyone’s best interest, including the Prime Banks, since many of their loan contracts reference BBSW, and the investment funds, since BBSW is their performance benchmark. So to some extent, we should be able to rely on the survival BIS central bankers’ speeches instincts of all participants in the market to encourage more activity during the rate set. This is why we are proposing that the market convention should be for the Prime Banks to conduct their primary issuance and secondary market trading in terms of outright yields during the rate set window. Nevertheless, the current lack of trading activity during the rate set suggests that there may need to be more explicit incentives to encourage participation in the rate set, particularly from a broader range of NCD investors. Assuming the market shifts to trading on the electronic platforms, the improvement in market transparency that would result may be enough to encourage more buy-side participation. We note that some submissions suggested more onerous alternatives. For instance, one way to ‘encourage’ investors to transact at outright yields would be for the Prime Banks to charge a fee for Eligible Securities transactions negotiated at the BBSW rate. Alternatively, if the bulk of market activity continues to take place outside the rate set window, the Administrator could keep widening the window, which at the extreme could be a 24-hour period to ensure that all market activity is within scope. We do not support these alternatives at this stage, as they would not be in the best interests of investors. However, if activity during the rate set continues to be too low to sustain BBSW in the medium term, then these alternatives may need to be reconsidered. So the key questions that we are left with are: • First, how should the transactions be executed during the rate set window for BBSW to be calculated as the VWAP? • Second, will market participants be willing to transact at directly negotiated rates rather than at BBSW? These questions are the focus of our continuing discussions with AFMA and market participants. While the CFR has an ongoing interest in BBSW as a systemically important financial benchmark, the ultimate responsibility for the BBSW methodology, and the implementation of any changes, resides with the administrator of the benchmark. The CFR appreciates that AFMA and market participants will need to give the proposal in the discussion paper further consideration, and that any associated changes to market practice and infrastructure will take time to implement. As a result, it will be necessary for the current BBSW methodology to be maintained for a period. To support this process, we have put forward a timeline for consideration of the proposal by AFMA and market participants as well as the implementation of changes by the administrator. We would like to see AFMA complete any further consultation and finalise a set of amendments to the BBSW methodology by the middle of this year, and for the changes to be implemented by the end of this year – although we acknowledge that the feasibility of this timeline will depend on the scope of the amendments to the methodology that are eventually implemented. Risk-free rates Next I would like to briefly raise some issues around whether the use of BBSW needs to be quite as widespread as it is. In a number of instances, BBSW has become the default reference rate without much thought being given as to whether it is the most appropriate reference rate. BBSW is a credit-based reference rate. It is based on the borrowing costs of the major banks, with the credit risk that entails embodied in the rate. For a number of purposes, a credit-based rate is completely appropriate. However, for other purposes, a rate that is closer to risk-free may be more appropriate. For instance, in recent years, market participants have moved to use overnight-indexed swap (OIS) rates more often when discounting the cash flows in their swaps. The FSB, through its official sector BIS central bankers’ speeches steering group (OSSG) on benchmark reform, is encouraging market participants to contemplate switching from credit-based benchmark rates like BBSW or LIBOR to risk-free rates, where appropriate. In the local market, there appears to be growing interest in using risk-free rates as benchmarks. Such a rate could be backward looking, like the cash rate, or forward looking, like OIS rates. As a first step, some market participants have indicated that a total return index of the cash rate would be a useful backward-looking benchmark. Implementing this would be straightforward, since the RBA already calculates and publishes the cash rate. Some market participants are also interested in referencing a forward-looking rate with equivalent tenors to BBSW, and we will continue to work with AFMA on the development of such a benchmark. One example where a change in reference rate could be contemplated is for floating rate notes (FRNs) issued by governments. FRN coupon payments are typically priced at a spread to BBSW. While referencing BBSW makes sense for FRNs issued by banks, it is less clear why governments should tie their coupon payments to a measure of bank funding costs. That is one example worthy of consideration. There are a number of others. I know this is not necessarily an issue you may have thought that much about until now. At the very least, I would encourage you to at least ask the question whether the product you are issuing or holding is using the most appropriate reference rate. Conclusion Let me conclude. Interest rate benchmarks such as BBSW are a very critical part of the plumbing of the financial system. Market participants need to have confidence in their robustness and integrity. To help ensure that is the case, the CFR has undertaken a consultation process on the BBSW methodology. The industry, working through AFMA and with the CFR, will need to act on these proposals to ensure that BBSW remains a trusted, reliable and robust financial benchmark. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 2 |
Keynote address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the UDIA National Congress 2016, Adelaide, 8 March 2016 | Philip Lowe: Resilience and ongoing challenges Keynote address by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the UDIA National Congress 2016, Adelaide, 8 March 2016. * * * Accompanying charts can be found at the end of the speech. I would like to thank Craig Evans for assistance in the preparation of this talk. It is a real pleasure for me to be back in Adelaide today. I would like to thank the Urban Development Institute of Australia (UDIA) for the invitation to be part of your National Congress in this beautiful city. I previously spoke at a UDIA National Congress in 2010. That year it was held in Sydney. On that occasion, I spoke about how and why the Australian economy had come through the severe global downturn in much better shape than most other countries. I spoke about the expected upswing in mining investment and the positive effect that it was likely to have on our economy over the next few years. And I spoke about three specific challenges: the need to expand the supply side of the economy; the need to get a better balance between supply and demand in the housing market; and the need to ensure that inflation remained low and stable. In the six years since then, a lot of water has flowed under the bridge. The global economy has had a recovery of sorts, although the average growth rate is still below what it was before the crisis. In Australia, the expected boom in mining investment did take place, leading to a large increase in our production capacity. For a time, this did result in the economy growing at an above-average pace, but this has been followed by a few years where growth has averaged below trend as mining investment returned to more normal levels. In terms of the challenges that I spoke about six years ago, the issue of expanding the supply side of the economy and boosting productivity growth is just as pressing as it was then. A bit more positively, in the housing market we now appear to have a better balance between supply and demand. And in terms of inflation, the outcomes in Australia – and almost everywhere around the world – have been lower than was earlier expected. Today, I thought it might be useful to again touch on these broad themes – the resilience of our own economy, the productivity challenge, the balance in the housing market and the inflation outlook. The resilience of the Australian economy So first to the Australian economy. Here, the main point to emphasise is the resilience of our economy and its ability to adjust. A few years back when we were looking down from the peak in the mining boom, there was considerable trepidation in some quarters about how Australia would manage over coming years. With commodity prices already declining and talk of an upcoming mining investment cliff, there were concerns about where the growth in output and, more importantly, the growth in jobs would come from. As things have turned out, though, we have managed pretty well so far, despite what has been a fairly difficult environment. Over the past two years, the prices of our commodity exports have declined by 40 per cent (Graph 1). Mining investment has also declined by almost 40 per cent, which is the equivalent of nearly 3 per cent of GDP. Yet over these two years, our economy has continued to expand at a reasonable pace, with growth over 2015 having been a bit stronger than was earlier expected and not too different from the long-term average. Importantly, there has also been sufficient growth in aggregate demand over recent times to keep the unemployment rate broadly steady and to accommodate a rise in the participation rate (Graph 2). Again, taking the past two years together, annual employment growth has BIS central bankers’ speeches averaged almost 2 per cent, which again is not too different from its long-term average. It is also a bit above population growth, so the share of the working-age population that is employed has also risen by around ½ percentage point over the past two years. The job creation has been particularly strong in a range of household services (Graph 3). Health care has been a stand-out, with annual growth in jobs averaging about 4½ per cent over the past two years. There has also been strong growth in jobs in business services, following a period of weakness a few years ago when exploration activity and pre-construction work in the resources sector were being scaled back. In contrast, there has been little job creation in the goods-related industries over recent years. This picture of our economy adjusting reasonably well to the changed circumstances is also evident in a number of other indicators. Over recent times, most business surveys have suggested that conditions have been around, or a little above, average. Business credit growth has picked up after having been subdued for quite a while. And last week's national accounts confirmed that growth in household spending has also picked up. While none of these indicators suggests that we are on the cusp of a return to the type of growth rates we saw before 2008, they do suggest that the economy is successfully rebalancing following the mining investment boom. This resilience reflects, in part, the flexibility of three key prices: the exchange rate, the price of money (or interest rates), and the price of labour. The effect of the exchange rate depreciation is evident in the improved conditions and prospects for a number of industries, including tourism, education, agriculture and parts of manufacturing. Just as the earlier appreciation helped the economy avoid overheating during the resources boom, the depreciation is now helping the economy adjust to lower commodity prices and lower investment in the resources sector. The effect of low interest rates is most clearly evident in residential construction activity, which increased by 10 per cent over 2015. This strong growth is having positive spillovers to other parts of the economy. Over coming quarters, we can expect a further increase in residential construction, although at a slower rate than seen recently. Finally, the low wage growth is one of the factors that has underpinned the reasonably positive employment outcomes. Over the past year, the Wage Price Index (WPI) has risen by just 2¼ per cent, the lowest outcome in the 17-year history of this series (Graph 4). Lower still is the growth rate in average hourly earnings measured by the national accounts. This measure, which takes into account compositional and other effects that are not captured by the WPI, is unchanged over the past year. These types of wage outcomes are much lower than what most people had become used to and lower than suggested by the historical relationship between wages growth and unemployment. While this low wage growth is one factor constraining consumption growth for many individual households, importantly, it means that more people have jobs and this is clearly a positive for both aggregate household spending and the broader society. So the flexibility in these key prices – the exchange rate, interest rates, and wages – has served us well. Our central scenario remains for growth in output to be a bit below trend over 2016, but then gradually to strengthen as the drag from lower commodity prices and mining investment wanes, and more of the increased capacity in the LNG sector comes on line. The main risks to this central scenario still seem to lie in the international sphere. The first couple of months of 2016 have been volatile ones in bond, equity and commodity markets. Our largest trading partner, China, is going through a difficult transition to a more consumption-led and service-based economy and is dealing with high levels of corporate debt and the complications of opening its capital account. On the monetary front, interest rates in the United States were recently increased for the first time in nine years, while the Bank of BIS central bankers’ speeches Japan unexpectedly moved one of its key interest rates into negative territory. In doing so, it joined the European Central Bank, the Swiss National Bank, the Swedish Riksbank and the Danish central bank with negative rates. And in a number of countries, there is an expectation that yet further monetary easing will take place. It remains to be seen what all this means for us. The recent international data have been mixed but, at this stage, do not suggest that momentum in the global economy has been lost. The monetary easing abroad is a complication for us, as it tends to put downward pressure on the currencies where the easing is taking place and thus upward pressure on the Australian dollar. More positively, lower oil prices – which primarily reflect increased supply capacity – are mostly good for global growth: they lower the cost of production for almost every firm in the global economy and put more money in the hands of consumers. The lower oil prices do, however, create financial strains for some economies and for some companies. So there are lot of cross-currents here that we are watching very carefully at the moment. I now want to move to the three challenges that I spoke about in 2010. Expanding the supply side – productivity The first of these was expanding the supply side of the economy – or lifting our productivity. Six years ago, the focus was on ensuring that the economy had sufficient productive capacity to avoid overheating during a period of strong demand flowing from the resources boom. Today, the focus is a little different. While we have done a pretty good job of adjusting to our changed circumstances, the not-so-good news is that growth in real income per capita in Australia has stalled (Graph 5). Indeed, average real income is no higher today than it was in 2008. This follows a 17-year period in which growth averaged a remarkable 3.1 per cent per year. During this earlier period, we benefited from: (i) strong productivity growth in the 1990s; (ii) a very large rise in our terms of trade; and (iii) favourable demographics, which helped increase the share of the population in paid employment. In all three of these areas, recent outcomes have not been as kind. It is more than coincidental that the timing of this change in our fortunes broadly coincides with the timing of increasing pressure on the federal budget, an increase in the general sense of economic uncertainty, slower gains in some asset prices and slower growth in wages and profits. Inevitably, when income growth is weak the effects are felt broadly through the community. Looking ahead, we should be able to look forward to somewhat better outcomes than over the recent past. We could expect that the drag on our national income from falling commodity prices will eventually lessen. And if current trends in employment continue, we could look forward to some further increase in the share of the population in paid employment. Both of these would be positive for real income growth. Australia's fundamentals also remain sound. We have a tremendous base of natural resources, a talented, diverse and growing workforce, a stable political and legal system, a highly regarded university system, and we are well placed to benefit from the increasing demand for services from Asia. But there is no escaping the fact that future growth in the average income of Australians relies largely on our ability to lift our productivity. While the rebalancing and resilience of our economy is certainly something to welcome, the longer-term challenge is to lift our living standards through finding new things to do and better ways of doing what we currently do. The need for this is made more pressing by the fact that the growth momentum in the global economy is less than it once was. Ultimately, productivity growth is heavily reliant on decisions made by businesses. But policy decisions can also make a difference. Here, there is no shortage of ideas. They cover strengthened competition policy, better provision and pricing of transportation infrastructure, developing a strong innovation culture, creating strong incentives for entrepreneurship and hard work, and investing in high-quality education. The task we collectively face, then, is to BIS central bankers’ speeches identify the right specific policies in each of these areas and then find ways of implementing them. Clearly, this is not an easy task, but neither is it an impossible one. Housing I would now like to turn to the second issue – the balance in the housing market. Again, when I spoke six years ago, the focus was on the pressures in the housing market arising from the rather unusual situation of having the growth rate of the population exceed that in the number of dwellings by a substantial margin (Graph 6). Since then, population growth has slowed, and the rate of growth in the dwelling stock has increased so that it now once again exceeds that of the population. Reflecting this increase, the share of GDP accounted for by the building of new dwellings has risen significantly and is now close to the various peaks reached over the past 50 years (Graph 7). Notwithstanding this, with spending on alterations and additions being relatively subdued, overall investment on residential construction remains some way below the previous peaks. This increase in the supply of dwellings has come on the back of a large run-up in housing prices in Australia's two largest cities. But the increase in supply now looks to be contributing to some moderation in the rate of increase in housing prices in these cities. It is also putting downward pressure on rents, with the CPI measure of rent inflation running at just 1.2 per cent in 2015, the lowest for 20 years (Graph 8). Whether or not these trends are maintained remains to be seen, and so we continue to watch developments in the housing market very closely. However, the overall picture does appear to be one of a better balance between supply and demand than was the case in 2010. As I noted earlier, the lift in residential construction has been an important element in the cyclical rebalancing of the economy. In the period ahead, we can expect a further increase in residential construction, although at a slower rate than took place last year. While this more modest increase will mean a more modest boost to overall GDP growth from home-building, it should assist with the sustainability of the current boom in residential construction. It is unlikely to be in our collective interest to have a further surge in the construction of new dwellings, as a share of the economy, then to be followed by what would surely be a larger and more prolonged decline later on. Overall, the recent data on building approvals suggest that we are on a reasonable path here. From a longer-term perspective, the challenge of providing an adequate supply of reasonably priced housing for an increasing population rests largely on the flexibility of land supply and, in particular, the supply of well-located land. This is because high housing costs largely reflect high land prices, not high construction costs. Here, it is zoning regulations and the transportation infrastructure that can make a material difference. In both areas, progress has been made since 2010, but there is more to be done. Inflation The final issue is the inflation outlook. Six years ago, inflation rates in almost all advanced economies were below the midpoint of central bank targets. This remains the case today (Graph 9). The average core inflation rate across the advanced economies is very similar to that in 2010, and headline inflation rates are lower than they were then, because of the decline in oil prices over the past year. Six years ago, Australia was one of the few advanced economies in which inflation was not below the midpoint of the target (in our case, 2½ per cent) (Graph 10). This was, perhaps, not surprising given the mining investment boom that was then taking place. But today, as in many other countries, we too find ourselves below the midpoint of the target, although by only a relatively small margin. Importantly, unlike most of these other countries, inflation in Australia does remain consistent with the medium-term target. BIS central bankers’ speeches It would appear that in many advanced economies the inflation dynamics are a little different from those in the past. In earlier decades, it was very rare for central banks to worry that inflation and inflation expectations were too low. Yet today, we hear this concern quite often, and the ‘unconventional’ has almost become conventional. One factor that has contributed to the low inflation outcomes is the fall in oil prices. But a more fundamental influence has been the low wage increases in most advanced economies. In a number of these economies, including the United States, Japan, Germany and the United Kingdom, the low wage increases have coexisted with fairly strong employment growth and not-so-strong output growth. This is evident in Graph 11. The left hand panel shows, for each country, average employment growth over the past two years relative to the long-term average. Similarly, the right hand panel shows recent GDP growth rates relative to the long-term averages. The pattern is reasonably clear: employment growth has been quite strong relative to historical trends, but output growth has not. It is also worth noting that each of these four countries is at, or near, conventional estimates of full employment. The commonality of this experience of low wage outcomes, strong employment gains and relatively subdued output growth suggests that some global influence may be at work. One possibility is that workers in the advanced countries perceive that they have less bargaining power than they had before, either as an after-effect of the financial crisis and/or the incremental globalisation of many service industries. Another possibility is that it is a reflection of the subdued growth in the global production of goods and the relatively strong growth in services, where output is more difficult to measure. Whatever the reason, the dynamics of labour markets are critical to the future path of inflation. It is possible that wage outcomes will remain very subdued even in countries with strong labour markets. If this turns out to be the case, then it is likely that inflation rates will also continue to be very low and monetary policy very accommodative. Alternatively, what we might be witnessing is just a slightly longer lag in the normal relationship between employment growth and wages. If this is the case, a pick-up in wage growth and inflation may not be too far away. Here, the United States is a test case of sorts given that its recovery is most advanced. Recently, there have been some signs of a pick-up in inflation there and it will be worth watching what happens quite closely over the next few months. For us, here in Australia, the continuing low wages growth means that CPI inflation is also likely to remain relatively low. While there is some upward pressure on the retail prices of imported goods as a result of the depreciation, this pressure is being muted by stronger competition following the entry of a number of overseas-based retailers into the Australian market. As the Reserve Bank has indicated for some time, this low inflation outlook provides scope for easier monetary policy should that be appropriate in supporting demand growth in the economy. An important factor here will be whether the growth in aggregate demand continues to be sufficient to accommodate the growth in our labour force. So, this brings me to the end of my remarks. I wish you the best of success for your National Congress. I hope that in another six years' time we can still be talking with some satisfaction about the resilience and growth in the Australian economy. And I suspect that the issues of productivity growth, the balance in the housing market and the inflation dynamics will be just as relevant as they are today, and as they were in 2010. Thank you and I would be happy to answer any questions. BIS central bankers’ speeches Graph 1 Graph 2 BIS central bankers’ speeches Graph 3 Graph 4 BIS central bankers’ speeches Graph 5 Graph 6 BIS central bankers’ speeches Graph 7 Graph 8 BIS central bankers’ speeches Graph 9 Graph 10 BIS central bankers’ speeches Graph 11 BIS central bankers’ speeches | reserve bank of australia | 2,016 | 3 |
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the FX Week Australia conference, Sydney, 17 March 2016. | Guy Debelle: The global code of conduct for the foreign exchange market Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the FX Week Australia conference, Sydney, 17 March 2016. * * * Today, I will talk about the Global Code of Conduct for the Foreign exchange market. I will reiterate the motivation for the work we are doing, then update you on where we are at with the process and outline the way forward. Why is the work going on? As I have stated on previous occasions, the foreign exchange (FX) industry is suffering from a lack of trust in its functioning. This lack of trust is evident both between participants in the market, but at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. A well-functioning foreign exchange market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Global Code is aiming to set out global principles of good practice in the foreign exchange market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to address the lack of trust as well as promote the effective functioning of the wholesale FX market. To that end, one of the guiding principles underpinning our work is that the Code should promote a robust, fair, liquid, open, and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. The work to develop the Global Code commenced in May last year, when the Bank for International Settlements (BIS) Governors commissioned a working group of the Markets Committee of the BIS to facilitate the establishment of a single global code of conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the code. 1 There are two important points worth highlighting: first, it's a single code for the whole industry and second, it's a global code. It's intended to cover all of the wholesale FX industry. This is not a code of conduct for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; its breadth is both across the globe and across the whole structure of the industry. The Code is intended to apply to all aspects of the wholesale foreign exchange market. In the Code itself, we spell out what we actually mean by the wholesale FX market. The one noteworthy part of the FX industry to which the Code generally doesn't apply is the retail market, as that is generally governed by retail-specific regulation in the relevant jurisdiction. I am chairing this work, with Simon Potter of the Federal Reserve Bank of New York leading the work on developing the code and Chris Salmon of the Bank of England leading the adherence work. Our Working Group comprises representatives of the central banks of all the http://www.bis.org/press/p150511.htm. BIS central bankers’ speeches major FX centres, drawing on the membership of the Markets Committee which is comprised of heads of the market operations areas of the 15 major currency areas. 2 Given our roles, we are all very much interested in the effective functioning of the FX market. Again, it is very much a global effort reflecting the global nature of the foreign exchange market. This work is also very much a public sector-private sector partnership. In that regard, we are being ably and vigorously supported in this work by a group of market participants, chaired by David Puth, CEO of CLS. The group contains people from all around the world, including Australia, on both the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants, drawing from the various Foreign Exchange Committees (FXCs) and beyond. Hence all parts of the market are being involved in the drafting of the code to make sure all perspectives are heard and appropriately reflected. At the outset we decided to split the topics we intend to cover in the Code into two parts. The first phase is the material we intend to put out in two months' time in May. It covers areas such as ethics, information sharing, execution (including mark-up) and confirmation and settlement. The second phase will cover topics such as governance, risk management and compliance, as well as further aspects of execution including e-trading and platforms (including last look), prime brokerage, and the unique features of FX swap, forward, and option transactions. One factor influencing our choice of which topics to cover in the first phase was our assessment of what issues the market was looking for clarity on sooner rather than later. One example of this is around information sharing, where many market participants have highlighted that they are unsure what information can be conveyed to counterparties and other market participants. While it is clear (or at least should be) that disclosing the details of a client's order book to a counterparty is not acceptable, market participants have noted that there is much less clarity around what level of aggregation, say, is necessary in order to convey market colour appropriately. As a result, it appears some market participants are being very conservative in sharing information, which can have implications for the effective functioning of the market. This is notwithstanding the guidance provided in this area in the Global Preamble put out by the global Foreign Exchange Committees, including the Australian Foreign Exchange Committee (AFXC), in March last year. 3 The Global Code takes the material in the Global Preamble and fleshes it out a bit more, including with some examples of what is, and isn't appropriate communication, and why. Similarly, there have been diverse opinions around what is appropriate behaviour in terms of order handling. While there have been some very public instances of inappropriate behaviour around order handling which have come to light in recent years, in other areas, the market is seeking greater guidance as to what principles should be followed, including the different standards that may apply depending on whether an intermediary is functioning as principal or agent. 4 This is one area that was not adequately covered in the pre-existing codes of conduct that the various FXCs had endorsed for the FX market. It is an area where we are aiming to provide the sought-after guidance. But we are not writing a procedures manual for order-handling. Rather we are articulating principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manual. Our aim in http://www.bis.org/about/factmktc/fxwg.htm. Available at http://www.rba.gov.au/afxc/about-us/pdf/global-preamble.pdf. I am not using these terms in the legal sense that is sometimes the case in particular jurisdictions, but rather in terms of common market parlance. BIS central bankers’ speeches articulating these principles is to provide market participants with the framework in which to think about how they handle stop-loss orders. The emphasis here is very much on the word ‘think’. The Global Code will not provide the answers to all your questions, but it should help you ask the right questions. In a similar vein, I will repeat a point that I have made a number of times in the past. One of our most central aims in drafting the Code is for it to be principles-based rather than rulesbased. There are a number of reasons why this is so, but for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. If it's not expressly prohibited or explicitly discouraged, then it must be okay seems to be the historical experience. Moreover, the more prescriptive and the more precise the code is, the less people will think about what they are doing. If it's principles-based and less prescriptive then, as I just said, market participants will have to think about whether their actions are consistent with the principles of the Code. So where we are up to in the process? Last week we circulated for comment the second draft of phase one of the Code via the various FXCs including the Australian FXC (and central banks in those countries on the Working Group without an FXC). This second draft incorporates comments on the first draft of the Code that we had circulated at the beginning of February. The first draft attracted over 1,400 comments. The comments were almost universally constructive and very supportive of the whole endeavour. I would like to thank those who took the time to provide them. In writing this second draft, we and the market participants group took full account of all of these comments. Those who provided them can rest assured we have taken heed of them. But in saying that, you may not see your comment directly embodied in the redrafting. This in part, reflects the diversity of views on some issues in the Code. That said, we have sought to incorporate the overall feedback in a manner that best reflects the objectives for the Code that I set out above, namely that the Code should promote a robust, fair, liquid, open, and transparent market. The comments on the second draft will be gathered over the next week or so. We will then take account of them and produce a revised draft early in April. There will be one final round for ‘fatal flaw’ comments after that before seeking endorsement by the various FXCs of a document we can take to the Global Foreign Exchange Committee meeting in New York on 25 May. For example, in Australia, we will be looking for the AFXC endorsement of the Code at our next meeting in early May. Following the meeting of the Global Foreign Exchange Committee, the first phase of the Global Code will be publically released. We have already started on the work of drafting the material in phase two of the Code. We will continue with that over the next year, again having a number of rounds of comment from market participants through the FXC process. Our intention is that the complete Code will be released following the Global Foreign Exchange Committee meeting in London in May 2017. At the end of that process, for the code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed by the FXCs and market participants more generally. That said, the process does not really end, because as the foreign exchange market continues to evolve, the Code will need to evolve with it. I will have more to say about how this ongoing evolution of the Code might occur in due course. Adherence to the code At the same time as we have been drafting the Code, we have also been devoting considerable time and effort to develop adherence mechanisms which promote and incentivise widespread adoption of the Global Code by market participants. Clearly, that has been an issue with the BIS central bankers’ speeches various existing industry codes that have been in place in a number of markets over many years. It is very evident that they were often ignored, wilfully or otherwise. For an industry code to have value in affirming appropriate norms of behaviour, it has to become effectively adopted in the marketplace. While adherence to a single, consistent code of good practice is widely regarded to be in the interests of the market, the Global Code will be voluntary. As I said earlier, we are working with the industry to produce a voluntary, principles-based code of conduct rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. There is already a substantial body of law and regulation that applies to the FX activities of many market participants, and this varies significantly across jurisdictions. This variation, coupled with the diverse nature of FX markets globally, means that a ‘one size fits all’ approach to adherence would not be appropriate. The final framework for adherence will need to strike the right balance between respecting the existing diversity across different markets, and maintaining consistency with regard to what is a global initiative. In that regard, we have articulated three principles which underpin our overall approach to adherence. • Universal: The Global Code should apply to all wholesale FX market participants, based on the activities they undertake and subject to compliance with any applicable regulations. We have been working hard to incorporate the perspective of all types of wholesale FX market participants into the draft Code, and we want it to be widely applicable across the market. • Proportionate: How wholesale FX market participants adhere, and demonstrate their adherence, to the Global Code should be proportionate and appropriate to the type of participant and the context of the local financial markets. • Transparent: the mode of adherence should be transparent, to enable monitoring and market discipline. It is worth stressing that the “proportionate” principle is not designed to lower the bar – it is designed to reflect the differences in the type and volume of market activities of certain market participants and the variation in FX markets worldwide. The concrete details of the adherence mechanisms remain a work in process. We will have more to say on this in New York in May. At this stage, our thinking is that there is unlikely to be a single adherence mechanism but rather a suite of mechanisms. Conclusion That, I trust, gives you a reasonable overview of the state of play on the Global Code. A lot of work has been done to get us to this point. There is still a lot of work to be done. The work to date has reflected a very constructive and cooperative effort between the central banks and market participants. All of us recognise the need to restore the public's faith in the foreign exchange market and the value of the Global Code in assisting that process and also in helping improve market functioning and confidence in how the market functions. I expect that cooperative relationship will continue as we see this process through to its conclusion in May next year. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 3 |
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to ASIC (Australian Securities and Investments Commission) Annual Forum 2016, Sydney, 22 March 2016. | Glenn Stevens: “How do we withstand shocks?” Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to ASIC (Australian Securities and Investments Commission) Annual Forum 2016, Sydney, 22 March 2016. * * * I thank Emily Perry for assistance in compiling these remarks. I'm pleased to be here to take part in ASIC's annual forum. The listed topic for this session was ‘can we withstand a major global shock?’ I'm going to take a few liberties with that title and re-frame it as ‘how do we withstand shocks?’ For it is inevitable that ‘shocks’ will come along 1 One way or another the human condition is characterised by things happening that were not well predicted and for which we are sometimes less prepared than we might, in hindsight, have wished to be. So the question is not if such events will occur, but when. There is a business cycle, and there always will be. There is a cycle of fear and greed in financial markets; it was ever thus. Things rarely move in straight lines and even when they do, as we start to assume that will continue, we set up the very dynamics that ensure it won't. Unfortunately, we will not be very good at forecasting these events. In fact forecasts, almost by definition, assume ‘shocks’ will not occur. About the best that forecasts can do is to sketch out the likely effects of shocks that are known already to have occurred. What that means is that we need resilient systems – systems that are robust to some things going wrong. We need flexible, adaptable economies. We need financial markets that price risk sensibly as opposed to habitually ‘pricing for perfection’. We need providers of finance, be they banks, so-called ‘shadow banks’ or capital markets, that have ample capacity to bear losses when things go wrong – because sooner or later some things will. With that framing, two questions to ask are: • What shocks are we grappling with at present? • How do we assess our capacity to cope with those, or worse? Recent Developments There have been a few developments that have attracted attention for their potential implications for the global and local economies. First, commodity prices have fallen considerably. In Australia, of course, this is part of the everyday narrative. Our terms of trade peaked about four and a half years ago and have fallen by about 35 per cent since then. This has a number of important effects and has caused considerable adjustment in the economy. To be clear about what we mean by the term, a shock is an event or development, typically unforecasted (and sometimes only dimly perceived even as it occurs) that has significance for the economy or financial system and requires adjustments of various kinds over a period of time. They can be adverse – consider the sudden reduction in risk appetite and drying up of liquidity in international financial markets in 2008. Shocks can also be positive – consider the way the entry of China into the global economy and the development of the efficient east-Asian manufacturing production chain in the 1990s lowered costs of consumer goods for the world. Or of the way Australia's terms of trade have, for the past decade, been way above their historical average. BIS central bankers’ speeches The effect of the terms of trade fall on which our public discussion typically focuses is the impact on the Federal government's fiscal position. Since the outlook for nominal GDP is critical to projections of tax revenues, the linkage of commodity prices to revenue forecasts has become a key part of the economic story. That is reasonable so far as it goes, though the sequence of downward revisions to terms of trade assumptions, while important, has really served to expose the deeper, and more profound, fact that the budget is structurally in deficit, for reasons largely unrelated to the commodity price decline. That is still something that, over time, we need to address. But the effect of the terms of trade fall is more than just the effect on the budget. It is a large change in relative prices and real incomes. It results in different paces of economic performance by industry and region. Other things adjust, including the exchange rate and allocation of labour and capital resources. It's complex but overall, in my judgement, the Australian economy is adjusting quite well in the circumstances – certainly far better than in other episodes of commodity price fluctuations we have seen in history. That said, the adjustment is still a work in progress. Out in the broader world, the price that has captured attention is that for crude oil, which has fallen by about two-thirds over the past two years. This was a genuine shock: it was not well predicted. But what sort of a shock is it? It matters a great deal whether the price is falling because demand for oil has slumped – say due to a major slowdown in global economic growth – or whether it reflects a large increase in the supply of oil. The evidence thus far is that demand has slowed a little, but supply has increased rapidly in recent years and is expected to remain at a high level this year. This matters because, usually, more supply of something and a cheaper price is good news, not bad. To be sure, lower oil prices require adjustment on the part of producers – corporate and sovereign. But this has always been so and an increase in the availability of energy and cheaper prices has generally, in the past, been seen as a plus for overall global growth – a positive ‘shock’. This was because the response of consumers of oil to a decline in its price was to consume more – not just more oil but other goods and services as well, using the higher real income afforded by lower oil prices. It was thought that this outweighed the negative effects of spending cutbacks in oil-producing countries. It seems people are less confident this time of a fall in oil prices being expansionary. Why so? The fact that the United States has become a larger oil producer (and a significant producer of the short-run ‘marginal barrel’) is clearly relevant. So is the possibility that consumers both there and in Europe may, for particular reasons, be more inclined to save any windfall from lower oil prices than they used to be. These factors may, for a time, work against the traditional positive effect. In addition, the price for oil was high enough, for long enough, that many investment and spending decisions were taken around the world that look, perhaps, not quite so sound in hindsight. Hence, producer countries have budget strains; some sovereign wealth funds are liquidating financial assets; spreads on debt instruments issued by energy companies have widened sharply; exploration and new investment is being curtailed rapidly. It seems as though the sheer strength and longevity of the preceding period of very high oil prices prompted behaviour that made some players more vulnerable to a price decline. That, of course, is not unknown in the history of commodity markets. Having said all that, people might be being a little too pessimistic about the effects of the fall in oil prices. It is still equivalent to a reduction in taxes for a very large number of consumers around the world who now have more disposable income to spend or to repay debt. The shareholders and state owners of the producing assets, who gained from the higher prices, are wearing most of the costs of the lower price, along with those who provided capital market debt funding. At this stage, though, it does not appear that the effects of lower oil prices are BIS central bankers’ speeches being greatly magnified through significant adverse effects on the banking system – though of course this has to remain under careful watch. The second development is that the outlook for global growth is assessed as having weakened, with forecasters expecting less growth in the global economy this year and next year than they did six months ago. The point here is not so much that growth is that weak: it is forecast to be higher than it was in the relatively mild global slowdown in the early 2000s, for example, and nothing like as weak as 2009. It is more that there have been a number of years now of belowaverage performance and the effects of that are cumulating. Many countries are finding the ‘strong, sustainable and balanced growth’ talked about in the G20 process to be rather elusive. The emerging world, which led growth after the crisis of 2008-09, accounts for much of the slower performance of late, and there has been a focus on China in particular.2 There is no doubt that China's growth trajectory today, and in the foreseeable future, is a slower one than that which we saw up to about 2011. The Chinese authorities have been telling us for some years that this had to occur. The real question is how successful they will be in landing a transition to a sustainable but still strong growth model, one that is less reliant on investment, more driven by domestic consumption and associated with less build up in leverage. They also have to manage the debt legacy of the previous period of expansion. The truth is that we can't know how all this will turn out. No one has done such a transition on this scale before. A third feature is that observers and investors have to grapple with a more complex policy environment. The Federal Reserve's interest rate decision in December was very well telegraphed and understood. So it, per se, doesn't really count as a ‘shock’. It resulted in the expected sorts of effects – like a turnaround in earlier international capital flows to emerging markets. Some of these actually began ahead of the event itself. At the same time, though, the very low rates of inflation and still very gradual pace of economic growth have led other central banks to seek further easing of monetary policy. Balance sheet measures have been stepped up and several European jurisdictions have applied negative interest rates to parts of banks' reserve holdings at the central bank. The same is happening in Japan. At this point, people are still trying to assess the implications of these changes. Meanwhile, for various reasons there has been renewed focus on asset quality in parts of the European banking system and Europe's resolution arrangements. Changes to China's exchange rate mechanism have attracted much attention. So, in summary, there has in recent months been somewhat more policy uncertainty. This, in turn, reflects the difficulties that policymakers are having in securing growth. Perhaps it's not altogether surprising, then, that we have seen some periods of elevated volatility in financial markets over recent months. Financing conditions for some emerging markets were becoming more difficult a year or more ago; that has generally continued. Major advanced economy sovereign bond yields, on the other hand, have remained very low or even fallen. The Bank for International Settlements has calculated that about US$6½ trillion in sovereign bonds, or about one-quarter of the JPMorgan government bond index according to one report, are now trading at negative yields in global capital markets. The Japanese government – by far the most indebted government in the developed world – can borrow for 10 years at a negative interest rate. But spreads for lesser rated sovereign and private debt have widened, in some cases quite significantly. Equity prices have been choppy and generally weaker. Exchange rates have become more volatile and have been particularly sensitive to shifts in perceptions about central bank actions. Incidentally, I have not seen evidence that weaker Chinese demand for oil has been a big factor for oil prices. If anything, what slowing in demand there is for oil seems to be occurring elsewhere in the world. BIS central bankers’ speeches Uncertainty about the future direction of the renminbi has been a factor in exchange markets, but the same must be said about the yen and the euro. How should we evaluate this period of volatility and reduction in risk appetite? Is it just reflecting the same information that is embodied in the softer global growth forecasts? Or is it telling us there has been a significant shock we don't see in other data? If it persists, could it be a shock that leads to a worse global outcome – by leading to a tightening of credit conditions, loss of wealth and confidence and therefore crimping demand? Alternatively, might the trend of the past couple of weeks, when markets seem to have been regaining a degree of composure, continue? If it does, might we look back on this recent period of turbulence as just a bout of market nervousness that that carries little lasting importance? These are the questions policymakers have to grapple with and as yet we do not know the answers. Resilience But if there were a material change to the global outlook happening – and, let me be clear, I am not saying there is, but if there were – how resilient are we? And how can we be more resilient? There are a couple of things to say at a global level. The first is that the global banking system is better capitalised and more liquid, and hence more resilient, today than it was eight years ago. This part of the financial sector is a good deal less likely to be an amplifier of other shocks than it was then. Of course this strengthening needs to continue; there is a way to go yet for full implementation of the various reforms. But progress is being made. It is noteworthy that much of the increase in financing in recent years has flowed through capital markets. It has to be acknowledged that bond markets are less liquid than they used to be. This is partly because the major international banks now do not commit the same size of balance sheet to market-making activities – and that stems, in part, from regulation. This, no doubt, is part of the story as to why markets have been more volatile recently, though it is probably not the whole story. Large investors are coping with this by accepting that it takes longer to move a parcel of securities. But some worry that liquidity may be much more significantly reduced in moments of stress, meaning that it may require much bigger price changes for markets to clear. As it is, some of the world's deepest and most important markets have, on a few occasions over the past year, seen very large price movements – thankfully for only fairly short periods. More generally, the search for yield has seen investors, including sovereign funds, insurers, and mutual funds held by retail investors, move into assets that are inherently less liquid. This leaves us, unavoidably, with a degree of uncertainty about how markets might cope with larger shocks, and how larger price changes for assets priced in those markets may feed back to the economy. Not surprisingly, liquidity management for asset managers and the question of liquidity conditions in markets in general are key themes for the Financial Stability Board at present. But for all that, it seems to me generally a good thing that (1) more of the credit risk is borne by entities or forms of financing generally less characterised by leverage; and (2) those entities that do have leverage (i.e. banks in the main) have less leverage than they used to. Such developments lessen the system's tendency towards crisis; resilience is greater. That said, all of this is still a work in progress and more progress is required. On the domestic front, the information we have received recently suggests that the Australian economy was growing at a respectable pace in the second half of last year. The national accounts data released this month showed that the economy expanded by 3 per cent over 2015, a bit better than we estimated at the time of our most recent Statement on Monetary Policy in February. This outcome seems to fit together with other pieces of information such BIS central bankers’ speeches as business surveys and labour market data, which improved noticeably over the course of 2015. So at the turn of the year the Australian economy seemed to have been picking up. That's a good starting point. In the case of business surveys, better conditions seem generally to have continued in the early part of 2016, though labour market data have been more ambiguous. The fact that Australia has a sound and credible macroeconomic policy framework, which could, if needed, respond as appropriate to significant negative events is also a good starting point. Even with interest rates at already low levels, and public debt higher than it was, there would, in the event of a serious economic downturn, be more room to ease both monetary and fiscal policy than in many, indeed most, other countries. Leaving aside the potential for macroeconomic policy responses, the economy's inherent ability to adjust has been on display through both phases of the mining boom. Of course we should always be looking for ways to improve that flexibility, but I think it should be said that businesses and their workforces have been much more flexible than once used to be the case. Turning to financial resilience, Australian banks' asset quality has generally been improving over the past couple of years. Like their counterparts abroad, in the post-crisis period the banks have lifted capital resources, strengthened liquidity and reduced use of short-term wholesale funding. So their ability to handle either a funding market shock or an economic downturn has improved compared with the situation in 2008. At this stage we do not see a material problem in Australian financial or non-financial entities accessing capital markets. If anything, net bond issuance by Australian banks has been strong over recent months, and to the extent that banks are able to take advantage of this availability to extend the term of their wholesale liabilities, that will further improve their resilience to any funding disturbances that may eventuate. Wholesale funding is a little more expensive than it was, though marginal funding costs are still no higher than the average cost of the funding being replaced. On the topic of loan quality, the strengthening of lending standards for housing that has resulted from the actions of both APRA and ASIC was timely. So often over the years, tighter standards tended to come too late and reinforced a downturn after it had begun. These measures have occurred ahead, so far as one can tell, of the point in the cycle when measures of asset quality start to deteriorate. Some moderation in house prices in some of the locations where they had been rising most rapidly, while not the direct objective of the supervisory measures, is also, in my judgement, helpful. In the business space, the banking system has fairly modest direct exposure to the falls in oil and other commodity prices, with lending to businesses involved in mining and energy accounting for only around 2 per cent of banks' total lending. More generally, competition to lend to business has increased over the past couple of years and business credit growth has picked up appreciably. Overall, this is to be expected and is a welcome development at a time when a missing element of the economic growth story is capital spending outside the mining sector, which appears to remain very weak. One notable trend is the aggressive expansion of some of the foreign banks active in the Australian market. Here there is a note of caution. If these are taking opportunities left on the table where local players (or earlier foreign players) were simply too conservative, all well and good. But one is duty-bound to observe that there is a history of foreign players expanding aggressively in the upswing only to have to retreat quickly when more difficult times come. It is worth remembering that cycle. Conclusion It seems to be part of the economic zeitgeist that people are continually looking for the ‘downside’ risks. It hasn't always been so - I recall lengthy periods when the mindset was always to see inflation pressures around every corner. That people seem to find it easier to BIS central bankers’ speeches imagine the downside today is a mark of the length of the shadow cast by the financial crisis, seven years on. For financial regulators and policymakers, it is, of course, our duty to look out for possible problems. At present, we can think of several, not all of which, by the way, are on the downside. Some of those may come to pass; some probably won't. But it is virtually impossible to say which ones are which. So, to repeat, the key thing is to try to build resilience in economies and financial structures so that, when shocks do occur, the damage can be contained rather than amplified. In that respect it is good that banks in most places in the world are stronger, though that process needs to be completed. The bigger role in financing being played by capital markets is also, on balance, probably a good thing, even though we are yet to be able to assess how such markets will perform under more stressed conditions. The local economy has been improving and the financial system overall gaining in resilience, albeit with a few pockets to watch. Given that and a reasonable track record of adapting to shocks, we have some grounds for confidence in our capacity to negotiate whatever lies ahead. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 3 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Economic Society of Australia (Hobart), University of Tasmania, Hobart, 6 April 2016. | Christopher Kent: Economic forecasting at the Reserve Bank of Australia Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Economic Society of Australia (Hobart), University of Tasmania, Hobart, 6 April 2016. * * * Accompanying charts can be found at the end of the speech I thank Daniel Rees, who provided invaluable assistance in preparing these remarks, and is the Head of the Bank’s new Macroeconomic Modelling Section (see below). Introduction Let me start by thanking the University of Tasmania and the Tasmanian branch of the Economic Society of Australia for hosting this event. Today I am going to talk about economic forecasting, which plays an important role in policy deliberations at the Reserve Bank of Australia (RBA). It assists in interpreting economic developments and, because monetary policy typically affects economic activity and inflation with a lag, it is a necessary part of determining and communicating the appropriate stance of policy. I’m also going to discuss the results of an external review of our forecasting methods and processes, which we have just published, and our responses to the recommendations therein. Our current approach to forecasting has been in place for some years. While it has served us well, we thought it was time to consider whether our methods and processes would continue to be appropriate and how we might improve upon them. To do this, we commissioned two eminent economists to conduct a review, Professor Adrian Pagan of the University of Sydney and Dr David Wilcox of the Federal Reserve Board of Governors. 1 The existing approach to forecasting at the RBA The process of economic forecasting actually involves a wide range of activities. The most familiar relates to the construction of forecasts that reflect our best estimates of future economic outcomes. 2 Each quarter in the Statement on Monetary Policy, we publish forecasts for Australia’s major trading partners’ GDP growth, as well as Australia’s terms of trade, GDP growth, unemployment rate and inflation over the next two-and-a-half years. However, these numbers are just a summary of an extensive process in which our analysts incorporate incoming data, assess the relevance of new events, construct forecasts for a large number of economic variables, analyse various scenarios and consider a range of key risks to the outlook. All of this provides a useful framework to guide policy deliberations and then communicate those decisions. This process may lead us to revise the economic outlook – either in response to unexpected developments or shocks, or to news that changes our views on how the economy is evolving. If a change in the outlook is judged to be significant, it may warrant a change in the stance of monetary policy. However, that link between the forecasts and policy is by no means a Professor Pagan is one of Australia’s foremost academic economists and served on the Board of the Reserve Bank from 1995 to 2000. Dr Wilcox is Director of the Division of Research and Statistics at the Federal Reserve Board of Governors in the United States. I use the term “forecast” somewhat loosely, since these are conditioned on a range of assumptions, such as a fixed nominal exchange rate and a particular path for the cash rate, and hence could better be described as “projections”. BIS central bankers’ speeches mechanical one. In part, that is because any policy response will depend on the nature of the change to the outlook, including whether it has been driven primarily by supply or demand shocks, and how persistent those shocks are likely to be. Also, any policy response will depend on an assessment of the extent to which the economy will adjust of its own accord. It is important to recognise that sufficiently flexible economies can do much to right themselves, with households and businesses responding to the signals provided by changes in prices, wages and the exchange rate. Such changes have played a major role in the adjustment of the Australian economy to the decline in commodity prices and mining investment over recent years. 3 Another important consideration is the sizeable degree of uncertainty about the outlook. While a revision to the central outlook might appear to be of substance, it may still be relatively small compared with the considerable degree of forecast uncertainty. And finally, other considerations, beyond the near-term outlook of the macroeconomy, may be relevant, including the prospects for financial stability. The role of models Modelling can play a useful role in the forecasting process, including by helping to identify the nature of the shocks affecting the economy. Models can also provide a sense of how the economy might respond to alternative policy paths or different assumptions about key variables, such as commodity prices or the exchange rate to name just two. In addition, models allow us to check whether our forecasts are consistent. For example, does the path for output and employment imply a plausible path for productivity? And do they imply patterns of economic behaviour that are broadly in line with historical experience? A recent instance is the decline in wage growth over recent years, which has been larger than implied by the historical relationship with the unemployment rate. Of course, we may be justified from time to time to think that history is likely to be a poor guide, but it’s worth being explicit about any such deviations. Finally, while models play an important role in the forecasting process, the value of models should not be overstated, particularly because no one model that we have captures all of the relevant features of an economy or consistently “beats” other forecasts. 4 Central forecasts Central forecasts attract a great deal of attention and commentary from financial market participants, the press and the general public. The extent of that attention is often unwarranted. As several of my colleagues have noted over the years, point forecasts should be treated with a healthy degree of scepticism. 5 It is unlikely that GDP growth or inflation will exactly match point forecasts, or even narrow ranges around those points. Instead, central forecasts are best thought of as our view of the most likely of a wide range of possible outcomes, with small changes in the forecasts unlikely to reflect anything more than a modest shift in the balance of risks. To avoid fallacies that can accompany false precision, we recently altered what we refer to as “Table 6.1” of the forecasts in the Statement by presenting ranges for GDP and inflation in ½ percentage point increments, rather than ¼ percentage point increments (shown below). No For a discussion of these issues, see Lowe P (2016), “Resilience and Ongoing Challenges”, Keynote Address to the UDIA National Congress 2016, Adelaide, 8 March. Models usually involve some reasonable simplifications of reality so as to make them tractable and possible to estimate. Such models will be unable to capture all relevant considerations all of the time. For example, see Stevens G (2011), “On the Use of Forecasts”, Address to the Australian Business Economists Annual Dinner, Sydney, 24 November; Lowe P (2010), “Forecasting in an Uncertain World”, Address to the Australian Business Economists Annual Forecasting Conference Dinner, Sydney, 8 December; Stevens G (2004), “Better Than A Coin Toss? The Thankless Task of Economic Forecasting”, Address to the Economic Society of Victoria and the Australian Industry Group, Melbourne, 17 August; and Stevens G (1999), “Economic Forecasting and Its Role in Making Monetary Policy”, Address to the Economic Society of Australia Forecasting Conference, Melbourne, 19 August. BIS central bankers’ speeches doubt that will not discourage some readers from using their rulers to measure the graphs and focus on revisions down to the nearest 0.1 percentage point! Also, some commentators will be tempted to draw attention to what they might describe as “large ½ percentage point changes” when the forecasts are revised, even though any such revisions may reflect much smaller adjustments if it is the case that the forecasts have merely crossed rounding barriers. 6 The key point I’d like to make here is that if we judge any forecast revision to be of substance worth noting, we’ll note it! To emphasise this point further, it is worth remembering that the available data are subject to a degree of measurement error. In the case of real GDP, for example, quarterly growth rates can easily be revised up or down by ½ percentage point or more in the first four years after the initial estimate (Graph 1). 7 The recent revision to GDP growth – of 0.2 percentage points in the September quarter of 2015 – was relatively minor, though the data now suggest that GDP growth picked up in the second half of 2015 to be more in line with the strength that was apparent in a range of indicators of the labour market and business conditions at that time. Starting points A critical element of forecasting is to have a sense of where the economy is now and in which direction it’s currently heading. This comes from carefully dissecting the incoming economic data in an attempt to disentangle signals from noise and determine the extent to which shocks will be long-lived or transitory. 8 In addition to publicly available data, we make use of information obtained from our business liaison program. We also use information gleaned from econometric models, which include both single-equation models of individual variables as well as larger models that attempt to capture the behaviour of multiple variables simultaneously. The various information sources that we use don’t always provide a clear message about where we are and where we are heading. Indeed, it is naïve to think that the truth can reside in a single source of data or a particular model. To an extent, this reflects the usual noise in the various types of information, as well as uncertainty about the strength of different economic relationships. Combining information from a variety of sources, and models, typically results in more robust conclusions than relying exclusively on a single source. The behaviour of inflation provides a timely example. A wide range of information suggests that inflation is low and likely to remain so over the next couple of years. This includes both structural (DSGE) and statistical (VAR) models of inflation. These attribute the outcomes over the past year or more, in part, to the influence of foreign “factors” – as captured by low inflation and low interest rates in the advanced economies. These can have a direct effect on inflation in Australia via the prices of imports. There are indirect effects as well, whereby spare capacity in product and labour markets globally may have contributed to relatively low inflation and wage outcomes in Australia. The models suggest that these influences on Australian inflation are typically quite persistent, which reinforces the message from other sources that inflation is likely to remain low for some time. To be clear, if an initial forecast of a particular number had been close but less than say 2¼ per cent, for example, it would have been rounded down to 2 per cent, but a minor upward revision of less than ½ percentage point could mean it subsequently rounds up to 2½ per cent. J Bishop, T Gill and D Lancaster (2013), “GDP Revisions: Measurement and Implications”, RBA Bulletin (March), pp. 11–22, discuss the pattern and size of revisions to real GDP over recent years. Lowe P (2010), “Forecasting in an Uncertain World”, Address to the Australian Business Economists Annual Forecasting Conference, Sydney, 8 December, describes the inputs into the forecast process in greater detail. BIS central bankers’ speeches Uncertainties For several years we have presented confidence intervals for GDP growth and inflation forecasts in the Statement (Graph 2). 9 These summarise the extent of uncertainty based on previous forecast errors. Since February of last year, we have also published an unemployment rate forecast and confidence intervals around that. In addition to confidence intervals, the forecasting process leads us to think about the risks associated with specific economic developments and to quantify those where possible. Each quarter, we discuss a range of scenarios that explore how the economy might respond under conditions that vary from the central case. For example, what if commodity prices, the exchange rate or overseas economic conditions evolve differently to the paths embedded in our central forecasts? These exercises help us to identify events that could have a meaningful effect on the economy and to which policymakers may need to respond. Background to the Pagan-Wilcox review We commissioned Adrian Pagan and David Wilcox to conduct a review of forecasting in Economic Group in late 2014. We asked for their views on whether there were areas we could improve upon, whether the tools of forecasting were the right ones and whether we were using the forecasts appropriately. We did not commission the Review as a result of any concerns about our recent forecasting experience or because we felt that our existing procedures were fundamentally flawed. But it was time for a careful health check of our approach. Professor Pagan and Dr Wilcox visited the Bank for two weeks during one of our regular forecasting rounds. They spent time with individual sections in Economic Group, examining our models and forecasting approaches in detail. They also met with senior management and attended our internal forecast discussions. Their review represents a thorough analysis of our forecasting procedures. We have made it publicly available today. I will attempt to summarise its key conclusions and describe how we have responded to the recommendations. The review’s conclusions and recommendations The Review concluded that our forecasting practices were fundamentally sound and produced information conducive to good policymaking. The reviewers praised the knowledge, motivation and technical proficiency of our analysts. They also commended the use of models and the spirit of open debate in our internal forecasting discussions. But there is always room to improve. The Review made a number of recommendations, which can be summarised in three categories: the development of new models; changes to forecast procedures; and organisational changes. Development of new models There were two recommendations regarding the modelling tools we used. • First, the Review recommended that we put additional resources into developing and analysing “full-system” or “general equilibrium” models of the economy – that is, models which account for the simultaneous responses of a large number of key variables to unexpected developments (or shocks). For information on the construction of these confidence intervals, see Tulip P and S Wallace (2012), “Estimates of Uncertainty around the RBA’s Forecasts”, RBA Research Discussion Paper No 2012–07. BIS central bankers’ speeches The Review recommended supplementing our existing models with one that incorporates our separate single equation estimates for a range of key variables into a system of equations. 10 • Second, the Review noted the enormous changes to the structure of the Australian economy over the past decade or more, particularly, but not exclusively, related to the mining boom. These developments caused shifts in the composition of economic activity, such as the large pick-up in mining investment that peaked in 2012. Hence, the relationships between economic variables may be different from the past. The Review recommended placing more emphasis on investigating the robustness of existing economic models to structural change and provided a number of suggestions on how to do this. 11 Changes to existing forecast procedures The Review also recommended some modifications to some of our forecast procedures. Forecast horizon It suggested we consider extending the forecasting horizon beyond two-and-a-half years. It was acknowledged that doing so would be more straightforward when using model-based forecasts. Moreover, the current approach has a number of advantages. A two-to-three year horizon is a period over which monetary policy, and what could broadly be termed “demandside” factors, tend to influence economic activity. Over longer horizons, “supply-side” influences, like changes in the trend rate of productivity growth or the non-accelerating inflation rate of unemployment (NAIRU), are likely to be more important. These factors are more difficult to forecast than short-run, demand-side influences, and are not affected by monetary policy decisions. However, following large and persistent disturbances, such as a once-in-a-century boom in commodity prices, the economy may not return to its steady state within the existing forecasting horizon. This could complicate the assessment of whether current policy settings are appropriate, hence the recommendation to extend the horizon. Cash rate paths Another recommendation was related to a “technical assumption” about the cash rate that underpins our forecasts. At the time of the Review, we typically assumed that the cash rate I should note that full-system models of one sort or another have a long history at the Bank and already play a role in the forecasting process. The earliest examples of such models date back as far as the 1970s and include the RBA1 model (Henderson J and P Norman (1975), “The Equations of the RBA1/74 Model of the Australian Economy”, RBA Research Discussion Paper No 7504) and the RBA76 model (Jonson P, E Moses and C Wymer (1976), “A Minimal Model of the Australian Economy”, RBA Research Discussion Paper No 7601). In the late 1990s, Economic Research Department staff constructed a small empirical model of the Australian economy. This model was documented in Beechey M, N Bharucha, A Cagliarini, D Gruen and C Thompson (2000), “A Small Model of the Australian Macroeconomy”, RBA Research Discussion Paper No 2000-05 and Stone A, T Wheatley and L Wilkinson (2005), “A Small Model of the Australian Macroeconomy: An Update”, RBA Research Discussion Paper No 2005-11. More recently, our staff have developed more complex dynamic stochastic general equilibrium (DSGE) models. These models were documented in Jääskela J and K Nimark (2011), “A Medium-scale New Keynesian Open Economy Model of Australia”, Economic Record (87), pp. 11–36 and Rees D, P Smith and J Hall (2015), “A Multi-sector Model of the Australian Economy”, RBA Research Discussion Paper No 2015-07. These sorts of models feature in our internal forecast meetings. However, I think it is fair to say that full-system models have not been fully integrated into our forecasting procedures and the nature of those models has been somewhat distinct from the single-equation models that most of our analysts work with day-to-day. For example, by estimating models incorporating time-varying coefficients or using techniques such as exponential smoothing that reduce the weight given to certain observations when estimating the parameters of a model. BIS central bankers’ speeches would remain constant across the forecast horizon. 12 This has the advantage of simplicity. Also, over short horizons it often provides a reasonable approximation to what econometric models and financial market participants would expect. However, over longer horizons a constant cash rate assumption may be less plausible, particularly when interest rates are far from average levels. The Review recommended considering alternatives to a constant cash rate assumption. A number of alternatives exist, including: the path implied by financial market prices; a path consistent with the past behaviour of the Bank as summarised by an estimated “monetary policy rule”; or an ad hoc path postulated by staff members. There is no consensus about which of these alternatives is optimal. 13 Broaden discussion of the forecasts The Review also made suggestions relating to the presentation of our forecasts in the Statement. In particular, the authors recommended that we publish a forecast for the unemployment rate. They noted that to assess the state of the real economy it is not sufficient to know the pace of GDP growth; one also needs to know how this rate of growth relates to potential growth and hence the extent to which spare productive capacity is rising or falling. While we have always focused on these concepts in our internal analysis, publishing unemployment rate forecasts provides useful information in this regard. Discussion of the risks An additional suggestion was to alter our discussion of risks to the forecasts in the Statement. The Review argued that there was scope to provide more guidance on the plausibility and implications of alternative scenarios, rather than merely providing a list of events that could affect the outlook. It is possible to come up with any number of scenarios that may cause economic outcomes to differ from a given set of forecasts. It is worth noting, however, that many plausible scenarios may have fairly benign implications. To give one example, we typically condition our forecasts on a constant exchange rate, even though it would be unusual for the exchange rate to remain steady for any length of time. However, the effect of an exchange rate movement will depend in large part on whether it has occurred in response to other developments, such as a change in commodity prices. The consequences of such exchange rate movements are predictable to some degree and, in many instances, have tended to help insulate the economy from adverse developments offshore or even domestically. In other circumstances, a large exchange rate movement (or even a lack of movement in the face of other developments) may represent an important shock to the economy. One can also imagine scenarios that are unlikely to occur but may have far more substantial implications for the economic outlook if realised. These scenarios can be difficult to quantify but may be worth discussing nonetheless. An example that we discussed in our most recent Statement was the potential for financial instability in China to lead to a sharp slowdown in economic activity there and in the Asian region more broadly. Organisational suggestions Finally, the Review made some recommendations regarding the organisation of Economic Group. However, we have used different conditioning assumptions at various times. For example, during the global financial crisis we conditioned our forecasts on financial market interest rate expectations. Some central banks, including the Bank of England and the European Central Bank, condition their forecasts on paths implied by financial market prices; others, including the Sveriges Riksbank and the Norges Bank, condition their forecasts on staff expectations of the future policy interest rate. BIS central bankers’ speeches The first was to establish a section dedicated to the development and use of full-system macroeconomic models. It would build upon the work of the existing modelling team and develop a new model. The establishment of such a section would facilitate the greater use of models within the Bank, increase cooperation between different sections generating the forecasts and help to enhance the familiarity of our staff with these types of models. The Review also encouraged the Bank to consider whether existing hiring and staffing policies encouraged the right mix of generalists and technical specialists. In particular, it highlighted macroeconomic modelling as an area requiring technical expertise. In addition, the Review questioned whether personnel across Economic Group were distributed optimally, with the suggestion that more staff could be dedicated to modelling if there were fewer staff monitoring overseas economies and/or participating in the Bank’s Regional and Industry Analysis section, which conducts liaison across the country. Responses to the review My colleagues and I have spent time discussing the Review’s conclusions, re-examining our existing procedures and developing appropriate responses. We have already implemented some of the Review’s recommendations: • We have added a quantitative discussion of our unemployment rate forecasts to the Statement, with a graph of confidence intervals to illustrate the extent of uncertainty. • The Statement’s Outlook chapter now provides a more comprehensive explanation of the uncertainties around our forecasts, including more information about the channels through which risks could affect the economy. • We have changed the nature of the cash rate assumption underpinning our forecasts. Since the start of 2015, we have conditioned our forecasts on the assumption that the cash rate moves broadly in line with the path implied by financial market pricing. • To increase the Bank’s capacity to use full-system models, we have established a new Macroeconomic Modelling section within the Economic Analysis Department. This has primary responsibility for generating model-based analysis to enhance the quality of our forecasting processes and policy advice. I should emphasise that this section will complement our existing forecasting processes, not replace them. As is the case at many other central banks, our forecasts will still be generated by a range of analysts and will feature a degree of judgement, rather than be mechanical, modelbased forecasts. However, the forecasts will be usefully informed by the insights and analysis that full-system models can provide. The Review recommended redirecting resources from monitoring overseas economies and conducting business liaison to other activities, particularly modelling. However, we have sourced staff for the new modelling section from across Economic Group more broadly and have no intention of reducing the extent of our liaison program. This reflected our assessment that the benefits of monitoring overseas economies and conducting domestic economic liaison go well beyond the direct contribution to our quarterly forecasting process. 14 In addition, the Liaison information helps fill information gaps to strengthen the Bank’s capacity to assess structural trends in the Australian economy. Two recent examples of this include better understanding the responsiveness of the construction sector to changes in interest rates and whether this has changed over time, and understanding why non-mining business investment has not picked up as forecast. The State Offices also play a key role in enhancing the Bank’s engagement with the public via presentations on economic developments to businesses and community organisations, teacher conferences, and university and school students across the country. For more information about the role of the RBA’s Business Liaison program see RBA (2014), “The RBA’s Business Liaison Program”, RBA Bulletin (September), pp. 1–6 and Heath A (2015), “The Role of the RBA’s Business Liaison Program”, Address to the Urban Development Institute of Australia, Perth, 24 September. BIS central bankers’ speeches liaison program provides valuable insights for forecasting. For example, during the mining investment boom, liaison provided timely and accurate information about construction projects that was not available elsewhere. Combining our liaison on each project has provided a reasonably accurate picture of what has transpired. Moreover, because a commodity price boom of this magnitude had not been experienced before, models estimated using historical data would have had difficulty anticipating the extent of the response of mining investment. Similarly, our analysts monitoring overseas economies help us to understand the economic and financial developments affecting our trading partners, particularly in the Asian region, in a way that would not be possible from using publicly available forecasts of a limited range of variables such as GDP and inflation from organisations like the International Monetary Fund or Consensus Economics. Conclusion The Pagan-Wilcox Review was a comprehensive health check of our forecasting approach. While the Review confirmed that our methods are fundamentally sound, it provided a number of valuable suggestions for how we could improve the way we forecast. We have already responded to many of the suggestions and are in the process of following up on others. While these changes are unlikely to see much of an improvement in forecast accuracy, they have the potential to enhance the role that forecasting plays in the policy process and facilitate the usefulness of the forecasts as an important tool of communication. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches | reserve bank of australia | 2,016 | 4 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Credit Suisse Global Markets Macro Conference, New York City, 19 April 2016. | Glenn Stevens: Observations on the current situation Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Credit Suisse Global Markets Macro Conference, New York City, 19 April 2016. * * * I thank Emily Perry for assistance in compiling these remarks. It is good to be in New York once again. Thank you to Credit Suisse for the invitation. By way of a preface to these remarks, I note that we have all just been in Washington, D.C. for the IMF and G20 meetings. With that context, my comments today are international in focus, rather than carrying any particular message about my own country. It has certainly been another interesting few months in global financial markets. Faced with falling commodity prices, diverging policy stances among major jurisdictions, the odd policy surprise and the sense that the economic growth outlook was a bit softer than had been assumed before, market participants had a lot to digest. To this picture was added a new dimension of uncertainty about the way regulations pertaining to some capital instruments might affect returns, and about the way resolution actions may work in some places. In the opening weeks of this year we saw sovereign yields in major advanced economies move towards historic lows, while spreads for some other sovereigns and corporates – especially high-yield obligations – moved out, with particularly sharp increases for bonds issued by resources companies. Share market volatility increased, with prices generally lower, especially for banks. Currencies of a range of emerging market countries, already marked down considerably over the preceding year, came under more pressure and sovereign spreads for some, though not all, of these countries increased. Since about the middle of February, markets seem to have regained some composure. A range of commodity prices have risen. Share prices have recovered some ground, though they remain mostly lower than they were a year or six months ago, and bank share prices in Japan and Europe are back around their recent lows. Investment-grade spreads have declined to where they were about six months ago. That is higher, to be sure, than a year or two years ago, but those spreads were unusually compressed. Even energy-related spreads have narrowed quite noticeably, to be back around their levels at the start of the year. The same is true for emerging market sovereign spreads, while yields on advanced-economy bonds remain close to their record lows. Emerging market currencies have generally appreciated, as have the currencies of commodity-exporting nations. So things have calmed down somewhat. That said, I think most observers and policymakers tend to the view that while some recovery is welcome, the relative ‘calm’ seems a little eerie – perhaps fragile. Certainly, these events have posed a few questions for policymakers, at least for the present speaker. Among the questions being considered over recent weeks were the following: • Does the “turbulence” simply reflect the same information that is embodied in the softer global growth forecasts that have been emerging over this period? In other words is it just a noisier version of a signal that is already being received? • Or has the financial volatility been telling us there has been a significant shock, the effects of which are coming but which we can’t see (yet) in forecasts or other data? • Alternatively, could the turbulence be a shock that leads to a worse global outcome – by leading to a tightening of credit conditions, loss of wealth and confidence, etc., and therefore crimping demand? • Or is it just a bout of market nervousness that carries little lasting importance? BIS central bankers’ speeches As always, it is impossible to be sure, but it would not be unreasonable, I think, to draw the tentative conclusion that while these movements did reflect some underlying softening in the global outlook that was already emerging, the reaction was overdone. Commodity prices are well down, but actually some prices had been declining for quite a while. Iron ore, for example, peaked as long ago as February 2011. Moreover, in many cases declining commodity prices reflect additional supply, which usually carries a different – positive – implication for global growth, as opposed to weaker demand. While global growth forecasts are being lowered, at this stage they see higher growth rates than in 2001, which was a relatively mild slowdown episode. Of course that is just a forecast – but so far there are not any actual data that invalidate that view. Given some recovery in markets of late, it seems too extreme to conclude that this event itself is developing into a significant financial shock with important additional macroeconomic significance beyond the softer global growth already understood to be in prospect. Having said all that, I don’t think we should write the episode off as just another bout of nervousness. Even if the volatility was not necessarily a reflection of fundamentals, it’s worth ensuring that we have extracted all the information we can from it. In addition, some quite big policy questions are lurking. It may be that these are playing a role in bouts of market nervousness – and could do so again. With that in mind, let me talk about a few issues – some familiar, but one or two rather newer. Liquidity One issue that both the regulatory community and many market participants have focused on for a while now is an apparent decline in market liquidity at a time when capital markets have become a more important source of funding for the economy. We can debate how much of that decline in liquidity is a result of regulation – and certainly some of it is – and how much simply owes to large players deciding to alter the way they run their businesses independently of regulatory changes. 1 There is at least some evidence that market liquidity is more costly than it used to be. Whether that is a big a problem is not clear. It could matter, for example, through the cost of capital to the productive side of the economy, as investors price the illiquidity of the assets they buy. This would mean that borrowers pay a little more than otherwise as a result. But are creditworthy borrowers actually having material difficulties accessing finance on reasonable terms, beyond what is explainable by their own macroeconomic fundamentals? It also seems that liquidity is somewhat less reliable even under conditions that could be thought to be “normal”, even in some of the largest sovereign markets in the world. Recent events have not obviously demonstrated any deterioration, nor any improvement, in that situation. We don’t know how liquidity will stand up under genuine stressed conditions. This is of increasing importance, particularly given the large growth of assets under management. Regulators are rightly emphasising the need for sound liquidity management by the asset managers, while market participants rightly point to the practices and tools they have to address these questions. But the key question is: what liquidity promise do the investors – many of them retail – think they have been given? Not what the fine-print says, but what are they actually assuming? If their assumptions are at variance with the genuine underlying liquidity in the relevant markets, there could still be trouble even with careful planning by It’s also important to recall that many markets never had that much real liquidity anyway. Outside the United States, corporate bond markets weren’t really liquid at any time and some observers say that even in the United States – the biggest corporate market – genuine liquidity was always a bit doubtful. BIS central bankers’ speeches asset managers. The Financial Stability Board continues to work on these issues and over time presumably we will be able to refine our assessments. Monetary policy Turning to other policies, when the financial crisis ushered in a very serious economic downturn in late 2008, central banks around the world reduced their policy rates dramatically – in a number of cases reaching the so called “zero bound”. Central bank balance sheet expansions were also enacted. These were initially associated with system-wide liquidity provision, but their more persistent use was an effort to provide more monetary policy support to weak economies. Together with more explicit guidance about the future path of short rates, these actions were aimed at reducing rates further along the yield curve. Some details differed, such as whether measures were configured to work through general capital market pricing or through the banking system, or indeed, through exchange rates. These details were determined by the institutional details of the various countries. But overall, “nonconventional” policies had the effect of lowering borrowing costs by pushing savers further out on the yield and risk curves. That is, they prompted a search for yield. They were supposed to do so. Portfolio substitution is part of how monetary policy works. When the central bank removes low-risk (and perhaps some not so low-risk) financial assets from the system as a monetary policy action, its intent is that, much further out along a long chain of substitution effects, consumers and businesses will respond by purchasing real goods and services. The extent to which demand for real goods and services was increased as a result of these actions is hotly debated. In the United States, business investment as a share of GDP had largely recovered by 2015. Of course, that might have happened anyway. Meanwhile, investment is still below pre-crisis levels in Europe. In Japan, it has never recovered to levels prior to the collapse of the bubble in the early 1990s. Of course, those levels may well have been unsustainably high, and we can’t know the counterfactual. So the debate continues. My personal view is that central bank policy at the global level was very effective at heading off a potential catastrophe after the Lehman event, but was always going to have limited capacity to accelerate the recovery. That is not to say central bank policy should not have done all it could, only that we should be realistic about what it can achieve. I think the evidence is consistent with that view. But of course it is also consistent with the argument that the measures were very effective, and that the recovery would have been much weaker in the absence of these actions. And that is why the debate will continue. In the meantime, there are some new areas of discussion emerging and, in a way, they are related. Interest rates and savers The first is the increasing concern that this world of ultra-low interest rates over a lengthy period is a big problem for savers. Here we are not talking about short-term trends. When everyone wants to save, the return to doing so will fall – that’s economics. In a cyclical sense that has to be expected, just as costs of borrowing rise when demand is strong. The issue is when long rates are very low for a long time. In such a world, the whole set of assumptions embodied in retirement income plans will be called into question. Increasingly, we hear commentary about the difficulty – or impossibility – of defined-benefit pension plans making good on their promises with long-term rates of return so low. The fact that accounting rules and regulation now strongly incentivise trustees to hold bonds – at the lowest rates of return in human history – so as to minimise mark-to-market valuation changes over the short term only exacerbates the problem. BIS central bankers’ speeches The problem is surely not confined to defined-benefit plans. Accumulation arrangements are still predicated on some set of assumptions about future income needs and returns. It may take longer but surely many of the owners of these funds are going to feel disappointment. The implicit promises – even if made only to themselves – about their retirement incomes are in danger of not being fulfilled. It is not a very daring prediction to say that these issues will loom ever larger over the years ahead. Some critics lay these problems at the door of the central banks, whose policy actions have worked to lower long-term yields on financial assets. If it were really true that central bank policies were the only factor at work in very low long-term interest rates, while at the same time they were not helping growth, the critics might have a point. But are central banks alone responsible for the decline in long-term interest rates? Real interest rates have fallen noticeably since 2007 – nearly a decade ago now. For there to be persistent effects on real interest rates as a result of central bank actions is perhaps not impossible, but seems contrary to everything we were taught when we studied economics. Monetary policy is not supposed to be able to affect real variables – like real interest rates – on a sustained basis. Presumably, changes in risk appetite, subdued growth and expectations that growth will continue to be subdued have also played a role in lowering real rates. Interest rates and growth This brings into focus the really critical question: what are the prospects for sustained growth in the future? Relatedly, what expectations about rates of return in the future are reasonable? The real economy needs to generate decent returns on the real capital stock that are then matched (risk-adjusted) by the yield on financial assets. The financial assets are, in the end, just paper claims on that flow of real returns – directly in the case of private sector obligations and indirectly for government obligations, which rely on being able to tax growing private incomes. If the real economy can’t perform to provide real returns to capital, there is nothing to back higher yields on financial assets. In that world, nominal and real yields on bonds would remain extremely low, the income being generated by those working with the capital stock would struggle to fund the benefits required by retirees through dividends and returns on bonds and bank deposits. Governments may not receive all the revenue they need to service their obligations. On the other hand, the stronger the prospects for long-term growth and good returns on the real capital stock, the smaller those problems will be and the more we can expect that, sooner or later, the yield on financial assets will be higher, in line with those real outcomes. Which outcome will it be? The more pessimistic are moving closer to the position of “secular stagnation”: that situation where the desire to save is so overwhelming and the apparent opportunities for profitable investment so weak, that real interest rates cannot equilibrate saving and investment for the system at positive rates of interest and full employment. The result is that the ex ante excess saving leads to a sustained below-full-employment equilibrium. The concept arose originally in the 1930s, but has recently been articulated by Lawrence Summers as a description of the current environment. 2 I still find this a bit too pessimistic, because I struggle to accept that today, to an extent virtually unprecedented in modern history, ingenuity, technological development, entrepreneurial drive and opportunity for improvement are so weak – so unprecedentedly See Summers L (2016) ‘The Age of Secular Stagnation: What Is It and What To Do About It’, Foreign Affairs, 15 February. BIS central bankers’ speeches weak – and people’s desire to defer gratification so strong, that the equilibrium real rate of interest is actually going to be negative over an extended period. What is undeniable, though, is that monetary policy alone hasn’t been, and isn’t, able to generate sustained growth to the extent people desire. Maybe this is simply the inevitable outcome after a period of excessive optimism and over-leverage – an essentially cyclical explanation, where the cycle is a low-frequency, financial one. Or maybe it is something more deep-seated and structural. That can all be debated. Either way, though, policies that encourage growth through means other than just ultra-cheap borrowing costs are surely needed. It is often said, rightly, that policymakers should try to avoid unnecessary policy uncertainty. For central banks, this has meant trying to be clear about our objectives and our reaction functions – and what we will, or might, do in various states of the world. Maybe we need to be clearer about what we can’t do. Monetary solutions are for monetary problems. If there are other problems in the underlying working of the economy, central banks won’t be able to solve those. Helicopter money? It is this recognition that purely monetary actions can go only so far, coupled with the need for some more growth and more inflation, that lies behind the recent discussion of “helicopter money”. In essence, this approach, were it to be attempted, would really be fiscal policy or a combined fiscal-monetary operation. It could involve unrequited transfers (gifts) to individuals’ bank accounts by the central bank – which diminishes the central bank’s net worth and so would require the acquiescence of its owner. Alternatively, it could involve direct funding of government spending by central bank finance – monetary-fiscal coordination. There would be a host of practical issues to sort out in the ‘helicopter money’ approach. Other commentators have talked about these recently. 3 The main complication is surely that it would be a lot easier to start doing helicopter money than to stop, if history is any guide. Governments have found that a difficult decision to get right. That is, after all, how we got to the point where direct central bank financing of governments is frowned upon, or actually contrary to statute, in so many countries. It would be a very large step to overturn those taboos, which exist for good reason. The governance requirements in doing so would be, if not intractable, at least very complex. Desperate times call for desperate measures, perhaps. Are we that desperate? Before we even got close to that point, one would have thought that for many governments today there must still be projects of an infrastructure kind that would, through conventional fiscal operations at current bond rates, offer returns comfortably above their cost of funding. Helicopter money is surely not needed in these cases. Questions may arise, in some jurisdictions at least, in the minds of citizens about the ‘soundness’ of such conventional policies. But if such questions arise about conventional fiscal actions, it seems unlikely that adding central bank financing to the mix would allay them. It all comes back to growth But the very fact – extraordinary as it is – that such possibilities are being openly discussed by serious commentators reinforces the point that, while people find global growth outcomes still a bit disappointing, we are reaching the limits of monetary policy in boosting it. Central See, for example, Bernanke (2016), ‘What tools does the Fed have left? Part 3: Helicopter money’, Brookings Institution, 11 April. BIS central bankers’ speeches banks must of course do what they can, consistent with their mandates, and they continue to explore options. It is certainly clever to find ways of pushing the effective lower bound for interest rates down a bit further. It is inventive to find ways of lending more, at more generous terms, to the private sector. But surely diminishing returns are setting in. My suspicion is that more and more people realise this. Maybe this has something to do with market confidence being easily rattled. There was a hint in the recent episode of the feeling that central banks didn’t have much left they could do, if things got worse. So in the end we will collectively have to face up to the question of whether trend growth is lower and, if so, what is to be done about that. A few candidates might be advanced as contributing to such an outcome. Demographics is one. What we might label productivity pessimism – or is it realism? – along the lines of Robert Gordon’s views might be another. Others would point to excess debt in many jurisdictions as another. If trend growth is lower and we can’t or don’t want to do anything about that, then expectations about future incomes, tax bases and so on will have to be reconfigured. People will need some explanation of why we have to accept that outcome. It may be that this reconfiguration is, in fact, what is happening. That would help to explain why ultra-low interest rates are not, apparently, as successful in boosting growth in demand as might have been expected. The future income against which people would borrow looks lower than it did, not to mention that the current income against which some already had borrowed has turned out to be lower than assumed. Alternatively, even if we accept that demographic headwinds and the legacy of earlier problems make growth harder to achieve, perhaps we can re-double our efforts to address the things that may be unnecessarily restraining growth today and in the future. They might be things like: • in some jurisdictions, inadequately capitalised banks • over-leveraged firms or households • poor incentives for risk-taking of the “right” kind • practices that unnecessarily impede productivity, or that slow down the re-allocation of capital from old industries to new ones. If we could engender a reasonable sense that future income prospects are brighter, that there is a good return to innovation and ‘real economy’ risk taking, and so on, then people might use low-cost funding for more productive purposes than just bidding up the prices of existing assets. Over time, the return on financial instruments could rise in line with returns in the real economy. Pension funds and insurers would be better able to meet their obligations. Governments would more easily service their debts. Citizens, having had some explanations as to why changes were necessary, would, in time, see some gains in their way of life, or at least some threats to their living standards abate. They would see less resort to very unorthodox policies, because there would be less need for them. And I can’t help thinking they would feel better about that. Conclusion We have lived through various bouts of financial market volatility before and doubtless these will recur from time to time. To some extent, this is inevitable. But we can limit the damage from these mood swings by keeping a strong focus on improving growth fundamentals. It is surely time that policies beyond central bank actions did more in this regard. Our inability, so far, durably to lift growth prospects is arguably the biggest vulnerability the global financial system faces today. This needs to be our focus. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 4 |
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Cards & Payments Australia Conference, Melbourne, 12 May 2016. | Malcolm Edey: The card payments review Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Cards & Payments Australia Conference, Melbourne, 12 May 2016. * * * Thank you once again for the opportunity to address this event. In some ways this is an awkward time to be giving a speech on card payments. As you know, the Reserve Bank Payments System Board has been conducting a comprehensive review of its regulation in this area. That review is now nearing completion. It is expected to be finalised at the Board’s next meeting, which will take place next week. Obviously I can’t pre-empt any decisions that might come out of that meeting. Instead what I would like to do is offer a kind of curtain-raiser, by summarising the history of the review and the way it has unfolded to date. I plan to do that under three headings: the background, the issues and the process. The background Let me begin with some brief background. The current arrangements for payments system regulation date back to the Wallis reforms that were enacted in 1998. Those reforms: • established a separate Payments System Board of the Reserve Bank with a majority of independent directors, • gave the Board the power to designate payment systems, and to set regulatory standards for designated systems in relation to such matters as access and pricing, • set the policy objectives of the Board as efficiency, competition and stability. The Wallis Report recommended an initial focus on credit cards, and accordingly this was the first area of regulatory action taken by the new Board. The four-party credit card schemes were designated in 2001 and, after a period of consultation, a package of reforms was implemented from 2003 onwards. The key elements of that package are well known and are still in place. They included: • A weighted average cap on interchange fees of 50 basis points • An access regime for credit card schemes, and • Removal of no-surcharge rules imposed by the schemes. Subsequently a package of reforms for debit cards was introduced in 2006. The thinking behind these regulatory measures was heavily focused on the efficiency of price signals to consumers. Interchange fees and surcharging rules were at the heart of this, and it is not surprising that they remain central to the current review. The Board’s early work recognised that interchange fees play an important role in influencing the incentives to use particular payment instruments. In commercial terms, interchange fees serve the purpose of rebalancing incentives between issuers and acquirers and, to the extent that the fees are passed on to end users, between cardholders and merchants. In mature systems with wide coverage, merchants may have little power to decline cards, regardless of cost. If so, the main decision-making power over the choice of payment instrument rests with the consumer, who typically benefits from reward points funded by interchange revenues. The higher cost cards (from the point of view of the merchant) are also those that tend to offer the highest rewards to the cardholder. This configuration of incentives creates a BIS central bankers’ speeches misalignment between the incidence of fees (mainly with the merchant) and the decision making power (which rests mainly with the cardholder). In formulating its early reforms, the Board took the view that this was inefficiently favouring the use of higher cost payment instruments and hence pushing up merchants’ costs. Closely related to this was the role of surcharging. In the Board’s view, no-surcharge rules reinforced the problem of inefficient price signals by preventing relative costs from flowing through to the person making the decision of which payment method to use. Hence on both these issues the Board concluded that there was a case for regulatory intervention. These core issues of pricing, access and surcharging rules have since been taken up by a number of other regulators around the world. And they have continued to be a focus of attention and debate domestically, both for policymakers and for a wide range of interested stakeholders. It was always intended at the time of the initial reforms that they would be subject to periodic review. The Board conducted the first such review in 2007/08. That review concluded that the reforms had improved the efficiency of card payment systems in some important respects: they had improved access, increased transparency and led to more appropriate price signals to consumers. One important element of that was a significant reduction in average merchant service fees for card payments. In the five years following the initial credit card reforms, for example, average merchant service fees for the regulated card schemes fell by 60 basis points. Competitive pressures generated similar reductions for the unregulated three-party card systems. As part of its review at that time, the Board considered some alternative regulatory approaches. For example, it gave serious consideration to reducing the credit card interchange benchmark from 50 to 30 basis points. It decided not to do so at that time, but left the option on the table for subsequent review. The Board also considered stepping back from formal regulation and relying instead on undertakings from industry, including an undertaking that average interchange fees would not rise in the absence of regulation. However, the industry was unable to arrive at suitable undertakings, and that approach was not adopted. Another important part of the background to the current review was the Financial System Inquiry (the Murray Inquiry) announced by the government in November 2013 – the first major system-wide review since Wallis. The Murray Report, released in December 2014, endorsed the overall approach to reform undertaken by the Board since it was established. But it also recommended that the Board undertake a further review in some areas, particularly in relation to interchange fees, surcharging and competitive neutrality (including the competition between companion cards and the four party schemes). The Reserve Bank had itself flagged some of those issues in its submission to the Inquiry. Following on from the Murray Report, the Bank launched its own review of card payments regulation in March 2015, with the publication of an issues paper and the commencement of public consultations. Preliminary conclusions were published in December 2015, and these have been the subject of a further round of consultations in the period since then. I will have more to say about the consultation process a bit later. The issues With this background, the Bank’s current review process has focused on three main areas of card payments, namely companion cards, interchange fees and surcharging. Let me elaborate on each of those. Companion cards I will start with companion cards. BIS central bankers’ speeches It has been just over a decade since the Bank first considered the case for regulating interchange-like payments made by American Express to its partner banks under companion card arrangements. Since then, issuance of companion cards has grown faster than that for the four-party schemes, and the combined share of credit and charge card transactions accounted for by Diners Club and American Express has noticeably increased. The change largely occurred in two steps coinciding with the introduction of companion cards by the major banks. At the same time, evidence cited in our consultation paper points to a steady increase in the importance of companion cards within the overall American Express card business in Australia. Some merchants have indicated that an increased cardholder base as a result of companion card arrangements has increased the pressure for them to accept American Express cards. For reasons that I have already outlined, differentials in interchange-like payments can have an important influence on the incentives to use particular payment methods, and these developments in companion card usage suggest that the different regulatory treatments for the two arrangements may have been a factor in shaping the development of the market. In the Bank’s view, an efficient payments system is promoted where the relative prices of different payment methods consistently reflect their relative resource costs. In reviewing this area, the Bank has indicated that three options have been under consideration. Those options are to retain the current arrangements, to remove regulation of the four-party schemes, and to regulate interchange-like payments for companion cards so that they would be subject to the same cap as the four-party schemes. In its consultation paper released in December last year, the Bank indicated that it favoured the third of those options, and this has formed the basis for further consultation in the period since then. Interchange fees The second main area under review relates to a range of issues around interchange standards. The interchange benchmarks set by the Board are the primary instrument for the Bank to anchor credit and debit card interchange fees at a desired level. The current benchmarks of 50 basis points for credit cards and 12 cents for debit have been in place since 2006. As I mentioned earlier, reductions in those benchmarks were considered, but not adopted, at the time of the 2007/08 review. In the period since then, the Board has remained concerned that interchange benchmarks may still be higher in Australia than is desirable for payments system efficiency. Another concern has been the proliferation of interchange categories over time and the widening dispersion of interchange fees. Often these work to the disadvantage of smaller merchants who do not benefit from preferential strategic rates. As at September last year, the average credit card interchange rate faced by non-preferred merchants was 55 basis points higher than the rate faced by preferred merchants; for debit cards the difference was around 13 cents. At the individual merchant level, these differences can be much bigger. In its December consultation paper the Bank set out a series of regulatory options in this area. They included retaining the status quo, reducing the weighted average benchmarks, and supplementing those benchmarks with hard caps on individual transactions. A fourth option of removing interchange regulations, while strengthening transparency of these fees to merchants, was also included. The Board’s preliminary assessment was in favour of a mix of the second and third options I just described. This would involve retaining the existing weighted average of 50 basis points for credit cards, supplementing it with a hard cap of 80 basis points on individual transactions, and reducing the debit benchmark to 8 cents. Once again, this was not a final decision but was announced as a basis for the subsequent phase of consultation that is now being completed. BIS central bankers’ speeches As well as looking at the overall level of interchange fees, the Review is also considering a number of related issues concerning coverage and compliance. On coverage, the issues discussed in the December paper concern commercial cards, foreign-issued cards and pre-paid cards. Currently commercial cards are included within the scope of the Bank’s interchange standards and hence form part of the calculation for the purposes of compliance with the weighted average benchmark. A number of interested parties have argued that these cards should be exempted, especially in the event that interchange caps were lowered. They argue, for example, that commercial cards typically provide a higher value of associated services than other card types, with fewer noninterchange revenue streams, and that these features could justify higher fees. On the other hand, consultations also suggest that these cards provide significant benefits to both sides of the market, and hence it is not clear that higher interchange fees are needed to promote their use. The Bank has also noted that, since commercial cards typically carry higher interchange fees than consumer cards, their exemption would amount to a de facto loosening of the weighted average cap. Foreign-issued cards are currently excluded from the benchmark calculations, and the question is whether these should be brought within the scope of domestic regulation for transactions acquired in Australia. Here a key consideration is the possibility of circumvention. Foreign-issued cards used in Australia typically carry a much higher interchange fee than the domestic benchmark, and under current arrangements could be used to circumvent the domestic cap. At this stage, however, the market share of foreign issued cards in Australian card transactions is still relatively small – around 3 per cent. In response to the December consultation document, Mastercard and Visa (among others) have made a number of arguments for retaining the existing treatment of foreign-issued cards, and these are being carefully considered. For domestic pre-paid cards, the Board is similarly considering whether these should be brought within the scope of the existing standard. The issue concerning the compliance mechanism can be stated fairly simply. The current mechanism operates on a three-year compliance cycle, such that the weighted average benchmark has to be met in November of every third year. Since the mix of card transactions within any system tends to shift towards the higher cost cards over time, average interchange fees have tended to rise during each three-year period. This in turn has had the paradoxical effect that the actual weighted averages for the Visa and Mastercard schemes have been almost always above the cap. The Board’s intent, however, is that average fees should be below the cap, not above it. That is what a cap means. The review process is consulting on options to tighten the compliance mechanism in keeping with that intent. A related question on compliance concerns the possible regulation of scheme payments to issuers. These marketing and incentive payments are bilaterally negotiated and can be quite material in value, and the flexibility of such payments means that they can be structured in ways to circumvent interchange regulation. Internationally, regulators have moved to limit these types of payments. Under European regulation, for example, they are treated as if they were interchange payments. As part of its Review, the Board is considering whether a similar treatment should be adopted here. The preliminary position announced in December was in favour of that option. Surcharging The third main area under review by the Board is surcharging. As I have already mentioned, the Board has long held the view that the ability to surcharge for more expensive payment methods is part of an efficient payment system. The ability to surcharge expands the options available to merchants beyond a binary decision to accept or reject a card, and it allows price signals to pass through to the consumer who decides which payment method to use. BIS central bankers’ speeches Nonetheless, efficient surcharging should reflect the cost to the merchant. When the Board’s initial surcharging reforms were put in place in 2003 it was expected that market forces would provide a sufficient discipline on surcharging behaviour. Since then, however, evidence of excessive surcharging in some industries has accumulated. The Board revised its regulation in 2013 to give schemes greater power to prevent excessive surcharging, but those arrangements proved difficult to enforce. This has prompted a further review by the Board as part of its current process. As well as consulting with the full range of interested stakeholders, the Bank has had discussions with the ACCC and Treasury about possible policy approaches. The Board’s proposed response builds on the recent Government measures to strengthen ACCC enforcement powers in this area. The main elements of the coordinated approach were set out in the December consultation paper. These are, that: • Government legislation bans excessive surcharging, defined as surcharging in excess of the Reserve Bank standard • The Bank’s standard is based on a simple and verifiable measure of the cost of acceptance, with appropriate transparency of costs to merchants • The ACCC has enforcement powers in cases of excessive surcharging by merchants, and • The Bank’s standard continues to stipulate that schemes may not have nosurcharge rules. Under the Bank’s preferred approach, acquirers would be required to provide merchants with regular statements of the cost of acceptance for each payment method. The cost of acceptance would have to be expressed in percentage terms unless the acquirer fees for that payment method were fixed across all transaction values. As a result, surcharging would normally also have to be percentage based. Among other things, this would rule out the current system of fixed-dollar surcharges in the airline industry, which would appear to result in significant over-recovery of payment costs on low-value fares. Again I stress that this is still a preliminary assessment, and decisions will be finalised next week in light of the consultations that have taken place in the interim. I have had to skate over a lot of detail today. But, taking all these elements together, the current review can be seen as a continuation of the approach adopted by the Board since its inception and endorsed by the Murray Report. It maintains a focus on efficiency of price signals and competitive neutrality, which have been core principles in the reform strategy from the start. The process So far I have described the background to the card payments review and the main issues that are being covered. I would like to conclude now with some comments about the process. Under the Payment Systems (REGULATION) Act 1998, any standards or access regimes that the Bank might propose to apply cannot be implemented without appropriate public consultation. In the case of the current review, the process of consultation and debate has been particularly extensive. This has been partly because of the comprehensive nature of the review itself, and also because of the complementary role played by the Murray Inquiry in examining many of the same issues. The Bank first publicly indicated its intention to hold a review of this nature in its March 2014 submission to the Murray Inquiry. That Inquiry, conducted through the course of 2014, itself undertook extensive consultations and made a number of recommendations to be followed up by the Payments System Board and the Australian Government. BIS central bankers’ speeches The Board launched its review with an issues paper in March 2015. In response to that, the Bank received more than 40 written submissions from interested parties, conducted meetings with 28 parties (some more than once) and hosted a roundtable with participants from 33 organisations. These included card schemes, banks, other financial service providers, consumer groups and government agencies. The Board’s preliminary assessment, taking all of that into account, was presented in a second consultation paper that was published in December, including a set of draft standards for further comment. The Bank received over 40 substantive submissions in this second round and held more than 50 further stakeholder meetings, all of which will be considered in the Board’s final assessment. As I said at the outset, I expect the Board will decide on a final set of standards at its meeting next week, with an announcement to follow soon afterwards. All up, it will have taken a bit over two years from the time when the Bank first signalled its intent to undertake this review until its completion. I sometimes hear comments to the effect that an even longer time should have been allowed for stakeholders to present their views, but the more common concern that I have heard has been from those who would prefer a faster process – consumers who would like to see faster action on excessive surcharging, or businesses who want greater regulatory certainty. I can only say in response that the Bank is bound to follow due processes and takes its responsibility to consult very seriously. But for those keen to see the final result, there is not long to wait. Once again, I thank all those who have taken part in the consultation process and I thank you for the opportunity to talk to you today. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 5 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the RMB FX Forum (appearance via video link), Beijing, 18 May 2016. | Guy Debelle: Developments in global FX markets and challenges in currency internationalisation from an Australian perspective Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the RMB FX Forum (appearance via video link), Beijing, 18 May 2016. * * * Thanks to David Halperin and Eden Hatzvi for their help in compiling these remarks. I am very pleased to have the opportunity to speak at this event today. Australia takes a keen interest in the ongoing process of internationalisation and liberalisation of the renminbi (RMB). I am sure you will hear many interesting perspectives on that subject today. I would like to talk about three things. First, I will talk a little about the use of the RMB in Australia. Second, I will talk about the RMB’s increasing role in the global economy and relate that to the work I am leading on the Global Code of Conduct for the Foreign Exchange Market. Finally, I will provide an Australian perspective on currency internationalisation and capital account liberalisation, reflecting on the challenges that emerged as Australia went through this process in the late 1970s/early1980s. 1 Turning to the use of the RMB in Australia. First, from the RBA’s own point of view, we have invested a portion of our foreign exchange reserves in RMB since 2013. This has allowed us to get direct insight into the way the FX and bond markets function in China, and has also allowed us to experience first-hand the benefits of the ongoing liberalisation that has occurred in recent years. In June 2015, the People’s Bank of China (PBC) reported that foreign central banks and monetary authorities held over RMB650 billion in RMB denominated assets and that has almost certainly grown larger today. The RBA and PBC also established a bilateral currency swap in 2012 for RMB200 billion that was renewed last year. The swap line highlights and supports the growing financial linkages between the two economies as well as trade and investment. To help further remove possible impediments to the use of RMB in Australia, an official RMB clearing bank began operation in Sydney in February 2015. In addition, Australia was granted an RMB50 billion RQFII quota for portfolio investments. Finally, for a number of years now, the Australian dollar has been directly traded against the RMB in the onshore FX market. This has allowed for the growing use of RMB in Australia. That said, the use of RMB remains noticeably less than the value of trade between China and Australia. In the RBA’s conversations with Australian businesses that trade with China, one repeated concern raised that inhibits greater use of the RMB is the limited scope to hedge. In that regard, it is pleasing to see that RMB hedging instruments and markets are growing rapidly. The ability to hedge was a very important development in the internationalisation of the Australian dollar. I will come back to this later on in my talk. I will now talk about the increasing growth of RMB turnover in the foreign exchange (FX) market and relate to that the work on the Global Code of Conduct. A fuller discussion of this can be found in Debelle G and M Plumb (2006), ‘The Evolution of Exchange Rate Policy and Capital Controls in Australia’, Asian Economic Papers, 5(2), pp 7–29. Available at http://www.mitpressjournals.org/doi/pdf/10.1162/asep.2006.5.2.7. Bob McCaulay has also written extensively on currency internationalisation. See for example McCauley R (2015), ‘Does the US dollar confer an exorbitant privilege?’ Journal of International Money and Finance, Elsevier, 57(C), pp 1–14. Available at http://www.sciencedirect.com/science/article/pii/S0261560615001059. BIS central bankers’ speeches One of the most noteworthy developments in the 2013 Triennial survey of FX turnover, compiled by the Markets Committee that I chair at the BIS, was the rapid growth of RMB turnover since the 2010 survey. In particular, RMB turnover increased from US$34 billion per day in 2010 to US$120 billion per day in 2013. 2 The data for the 2016 Triennial FX turnover survey is in the process of being compiled now, based on a comprehensive survey of the FX market in April. I would presume that the 2016 survey is likely to show similarly rapid growth in RMB turnover over the past three years. In particular, turnover is likely to be bolstered by measures taken by the PBC to increase trade settlement and investment in RMB, as well as the various exchange rate initiatives that the PBC has taken since 2013. This includes increasing the flexibility of the RMB against the US dollar, with the trading band being widened to ±2 per cent from early 2014 and, more recently, the adjustment last August to the methodology for calculating the daily RMB fixing rate to make it more market-determined. The 2016 Triennial FX turnover survey will likely confirm that the RMB is solidly in the top 10 currencies in terms of turnover, and may indeed be closing in on the Australian dollar, which is in fifth place in terms of turnover. Along with the RMB’s recent inclusion in the SDR, this confirms the RMB’s status as a global currency. With that prominence, comes an expectation that the functioning of the market will evolve towards the standards of behaviour and operation of the global FX market. In that regard, some of you may be aware that a Global Code of Conduct for the FX market is being developed. I will now summarise that work for you and its potential relevance for the FX market in China. Why is the Global Code being developed? As you are probably aware, the various scandals and evidence of inappropriate behaviour in the global FX market that have come to light over recent years have seen an erosion of trust in the FX industry, which is impeding its functioning. This lack of trust is evident both between participants in the market, but at least as importantly, between the public and the market. The global FX market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. A well-functioning foreign exchange market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Global Code aims to set out global principles of good practice in the foreign exchange market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to address the lack of trust as well as promote the effective functioning of the wholesale FX market. To that end, one of the guiding principles underpinning the work on the Code is that it should promote a robust, fair, liquid, open, and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. I am confident that a similar set of principles are guiding the reforms to the FX market in China. See BIS (Bank for International Settlements) (2013), ‘BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2013’, available at http://www.bis.org/publ/rpfx13.htm; Rime D and A Schrimpf (2013), ‘The Anatomy of the Global FX Market Through the Lens of the 2013 Triennial Survey’, BIS Quarterly Review, December. Available at http://www.bis.org/publ/qtrpdf/r_qt1312e.htm. BIS central bankers’ speeches The work to develop the Global Code commenced in May last year, when the Bank for International Settlements (BIS) Governors commissioned a working group of the Markets Committee of the BIS to facilitate the establishment of a single Global Code of Conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the Code 3. I am chairing this work, with Simon Potter of the Federal Reserve Bank of New York leading the work on developing the Code and Chris Salmon of the Bank of England leading the adherence work. Our working group comprises representatives of the central banks of all the major FX centres, including China, drawing on the membership of the Markets Committee which is comprised of heads of the market operations areas of the 15 major currency areas. 4 Given our roles, we are all very much interested in the effective functioning of the FX market. Again, it is very much a global effort reflecting the global nature of the foreign exchange market. This work is also very much a public sector-private sector partnership. In that regard, we are being ably and vigorously supported in this work by a group of market participants, chaired by David Puth, CEO of our conference host CLS. The group contains people from all around the world, including China, on both the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants. Hence all parts of the market are involved in the drafting of the Code to make sure all perspectives are heard and appropriately reflected. At the outset we decided to split the topics we intend to cover in the Code into two parts. The first phase covers areas such as ethics, information sharing, execution (including mark-up) and confirmation and settlement. The second phase will cover topics such as governance, risk management and compliance, as well as further aspects of execution including e-trading and platforms (including last look), prime brokerage, and the unique features of FX swap, forward, and option transactions. The first phase of the Code has been completed and is set to be released next week on 26 May in New York following the meeting of the Global Foreign Exchange Committees. I would hope that you, as participants in the FX market in China, find the Code useful, readable and relevant to the functioning of the market here. Work on the second phase of the Code is already underway. Our intention is that the complete Code will be released following the Global Foreign Exchange Committees meeting in London in May 2017. At the end of that process, for the Code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed by market participants. While the Code is a voluntary code, to ensure greater adherence to the Code, we will also be outlining some steps we are taking in that regard next week in New York and will have a fuller suite of adherence mechanisms in London next year. Finally, let me turn to discussing some of the challenges that Australia faced as the Australian dollar became an internationalised currency. The Australian dollar was floated in 1983, as large net capital inflows (in part resulting from the relaxation of capital controls in the 1970s) made it difficult to control both the exchange rate and domestic monetary conditions. At the same time, most of the remaining capital controls were removed as these were only seen as a tool for maintaining the fixed exchange rate, and hence were no longer necessary. BIS (Bank for International Settlements) (2015), ‘Economic Consultative Committee statement on FX market best practices’, Media Release, 11 May. Available at http://www.bis.org/press/p150511.htm. BIS (Bank for International Settlements) (2016), ‘Foreign Exchange Working Group’, Media Release, 10 February. Available at http://www.bis.org/about/factmktc/fxwg.htm. BIS central bankers’ speeches In the decade prior to moving to a freely floating currency in 1983, Australia had been through almost all other forms of exchange rate regimes: a peg to the US dollar (as part of the Bretton Woods exchange rate regime); a peg to a trade-weighted basket; and an adjustable peg, where the frequency of adjustment increased substantially up until the time of the float. Both capital inflows and outflows increased substantially following the float in 1983 (Graph 1). The benefits of the floating exchange rate in assisting the Australian economy to respond to shocks are documented extensively elsewhere, as are the benefits in allowing greater independence of domestic monetary policy settings. 5 One clear demonstration of this is in the reduced volatility of domestic interest rates and the increased volatility of the Australian dollar (Graph 2). But the increased volatility of the Australian dollar is generally regarded as a positive development (as a mechanism of adjusting to shocks) and not a threat. Graph 1 G Stevens (2013), ‘The Australian Dollar: Thirty Years of Floating’, Speech at the Australian Business Economists’ Annual Dinner, Sydney, 21 November; Ballantyne A, J Hambur, I Roberts and M Wright (2014), ‘Financial Reform in Australia and China’, RBA Research Discussion Paper 2014–10. BIS central bankers’ speeches Graph 2 The increase in gross capital flows encouraged the development of domestic FX and hedging markets, to the point where, as I mentioned earlier, the Australian dollar is now one of the world’s most traded currencies, including a large swaps market. Australian corporates (particularly financial institutions) regularly issue debt in foreign currency, which is then swapped into Australian dollars. An active ‘kangaroo’ market (Australian dollar-denominated bonds issued by non-residents) provides natural counterparties to these swaps. Deep hedging markets allow Australian firms to hedge foreign currency risk relatively cheaply. This is important because Australia’s history of current account deficits means that it has accumulated a fairly large net foreign liability position. In the absence of hedging, this could be problematic were the Australian dollar to depreciate significantly. But after taking hedging into account, Australia has a positive net foreign currency asset position. 6 The existence of deep hedging markets further ensures that the benefits of a flexible exchange rate policy outweigh the costs. However, this process was not smooth. In the 1980s and early 1990s Australia experienced two painful episodes, one relating to residents undertaking unhedged foreign currency Rush A, D Sadeghian and M Wright (2013) ‘Foreign Currency Exposure and Hedging in Australia’ RBA Bulletin, December, pp 49–57. BIS central bankers’ speeches borrowing and the other to lax lending standards that, following the opening up of the banking sector to foreign entrants, led to a boom and bust in commercial property prices. Both these episodes contributed to better risk management practices for banks and regulators, including greater demand for hedging products, contributing to their development and a deeper financial market. Australia’s experience with the internationalisation of its currency is not the only possible path. But the path of Australia and other countries that have pursued financial reform and capital account liberalisation at the same time, nearly all of whom then experienced episodes of financial instability, suggests that it can be beneficial to establish a strong prudential supervision framework before the financial sector and capital account are fully liberalised. This mitigates subsequent risks to financial stability. In light of this history, and given the importance of China to the global economy, China’s authorities have good reason to continue pursuing a cautious and gradual program of financial reform. Conclusion Let me conclude. Australia has a deep interest in following the ongoing liberalisation of China’s financial markets and internationalisation of the RMB, given the strong linkages between the two economies. We welcome the steps that have been taken that have already significantly increased the role of the RMB in global financial markets. As the FX market in China becomes increasingly integrated into the global FX market, I would hope that the Global Code of Conduct for the FX market that is to be released (in part) next week can serve as a useful benchmark for the functioning of the FX market in China as much as we intend it to be for the global FX market. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 5 |
Opening remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Launch of Phase 1 of the Global Code of Conduct for the Foreign Exchange Market, New York City, 26 May 2016. | Guy Debelle: Global Code of Conduct for the Foreign Exchange Market – Phase 1 Opening remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the Launch of Phase 1 of the Global Code of Conduct for the Foreign Exchange Market, New York City, 26 May 2016. * * * I am very pleased to launch Phase 1 of the Global Code of Conduct for the Foreign Exchange Market. It has taken a concerted effort by a dedicated group of people, working on top of their normal responsibilities, to get us to this point today. Before talking about the material we have put out today, let me remind you why this work is occurring. As I have stated on previous occasions, the foreign exchange (FX) industry has suffered from a lack of trust in its functioning. This lack of trust has been evident both between participants in the market, but at least as importantly, between the public and the market. The market needs to rebuild that trust, so that participants and the public have much greater confidence that the market is functioning appropriately. A well-functioning foreign exchange market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Global Code sets out global principles of good practice in the foreign exchange market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to restore confidence and promote the effective functioning of the wholesale FX market. To that end, one of the guiding principles underpinning our work is that the Code should promote a robust, fair, liquid, open, and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. The work to develop the Global Code commenced in May last year, when the Bank for International Settlements (BIS) Governors commissioned a working group of the Markets Committee of the BIS to facilitate the establishment of a single global code of conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the code.1 There are two important points worth highlighting: first, it’s a single code for the whole industry and second, it’s a global code. It’s intended to cover all of the wholesale FX industry. This is not a code of conduct for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; its breadth is both across the globe and across the whole structure of the industry. The Code is intended to apply to all aspects of the wholesale foreign exchange market. I am chairing this work, with Simon Potter of the Federal Reserve Bank of New York leading the work on developing the Code and Chris Salmon of the Bank of England leading the adherence work. Our Working Group comprises representatives of the central banks of all the major FX centres in both advanced and emerging economies, drawing on the http://www.bis.org/press/p150511.htm. BIS central bankers’ speeches membership of the Markets Committee which is comprised of heads of the market operations areas of the 15 major currency areas. Given our roles, we are all very much interested in the effective functioning of the FX market. Again, it is very much a global effort reflecting the global nature of the foreign exchange market. This work is also very much a public sector-private sector partnership. In that regard, we are being ably and vigorously supported in this work by a group of market participants, chaired by David Puth, CEO of CLS. The group contains people from all around the world, on both the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants, drawing from the various Foreign Exchange Committees (FXCs) and beyond. Hence all parts of the market are being involved in the drafting of the Code to make sure all perspectives and insights are heard and appropriately reflected. At the global meeting of the Foreign Exchange Committees yesterday, the eight regional FXCs unanimously endorsed the first phase of the Code. At the outset we decided to split the topics we intend to cover in the Code into two parts. This first phase covers areas such as ethics, information sharing, aspects of execution and confirmation and settlement. The second phase will cover further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. We intend that the second phase will be completed in twelve months, such that the full Code can be published in May 2017. One factor influencing our choice of which topics to cover in the first phase was our assessment of what issues the market was looking for clarity on sooner rather than later. We have attempted to provide greater clarity on issues such as information sharing and order handling in the document released today. Alongside drafting the Code, we have also been devoting considerable time and effort to thinking about how to ensure widespread adoption of the Global Code by market participants. Clearly, that has been an issue with the various existing codes that have been in place in a number of markets over many years. It is evident that they were ignored on occasion, wilfully or otherwise. As I said earlier, we are working with the industry to produce a principles-based code of conduct rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. But we do expect the principles in the Code to be understood and adopted across the entire FX market. So we are setting out today our overall approach to adherence to the Code and we intend to work closely with market participants in the coming year to facilitate the development of market-based mechanisms which demonstrably embed the Global Code within firms’ culture and practices. These mechanisms need to be sensitive to existing law and regulation and to the diverse nature of FX markets globally. Hence a ‘one size fits all’ approach to adherence would not be appropriate. We need to strike the right balance between respecting the existing diversity across different markets, and establishing globally consistent and effective adherence mechanisms. The success of the Global Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. That is why the Global FXCs have issued today a joint statement of support making clear their intention for the Global Code to become an integral part of the wholesale FX market. Furthermore the BIS central banks are today signalling their commitment by announcing that they themselves will follow the Code, and that they expect that their counterparties will do so too. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 5 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the ASIFMA/GFMA Liquidity Conference (appearance via video link), Hong Kong, 14 June 2016. | Guy Debelle: The global code of conduct for the foreign exchange market (update) Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the ASIFMA/GFMA Liquidity Conference (appearance via video link), Hong Kong, 14 June 2016. * * * Thank you for having me here today to talk about the Global Code of Conduct for the Foreign Exchange Market. As you may know, Phase 1 of the Code was launched in New York in late May. 1 Today I will reiterate the motivation for the work we are doing on the Global Code, then update you on where we are at with the process and outline the way forward. Why is the work going on? As I have stated on previous occasions, the foreign exchange (FX) industry is suffering from a lack of trust in its functioning. This lack of trust is evident both between participants in the market, but at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. A well-functioning foreign exchange market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Global Code sets out global principles of good practice in the foreign exchange market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to restore confidence and promote the effective functioning of the wholesale FX market. To that end, one of the guiding principles underpinning our work is that the Code should promote a robust, fair, liquid, open, and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. The work to develop the Global Code commenced in May last year, when the Bank for International Settlements (BIS) Governors commissioned a working group of the Markets Committee of the BIS to facilitate the establishment of a single global code of conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the code. 2 There are two important points worth highlighting: first, it’s a single code for the whole industry and second, it’s a global code. It’s intended to cover all of the wholesale FX industry. This is not a code of conduct for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; its breadth is both across the globe and across the whole structure of the industry. The Code is intended to apply to all aspects of the wholesale foreign exchange market. http://www.bis.org/mktc/fxwg/gc_may16.pdf. http://www.bis.org/press/p150511.htm. BIS central bankers’ speeches I am chairing this work, with Simon Potter of the Federal Reserve Bank of New York leading the work on developing the code and Chris Salmon of the Bank of England leading the adherence work. Our Working Group comprises representatives of the central banks of all the major FX centres, drawing on the membership of the Markets Committee which is comprised of heads of the market operations areas of the 15 major currency areas. 3 Given our roles, we are all very much interested in the effective functioning of the FX market. Again, it is very much a global effort reflecting the global nature of the foreign exchange market. This work is also very much a public sector–private sector partnership. In that regard, we are being ably and vigorously supported in this work by a group of market participants, chaired by David Puth, CEO of CLS. The group contains people from all around the world on the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants, drawing from the various Foreign Exchange Committees (FXCs) and beyond. Hence all parts of the market are being involved in the drafting of the code to make sure all perspectives are heard and appropriately reflected. At the outset we decided to split the topics we intend to cover in the Code into two parts. This first phase covers areas such as ethics, information sharing, aspects of execution and confirmation and settlement. The second phase will cover further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. We intend that the second phase will be completed in twelve months, such that the full Code can be published in May 2017. One factor influencing our choice of which topics to cover in the first phase was our assessment of what issues the market was looking for clarity on sooner rather than later. One example of this is around information sharing, where many market participants have highlighted that they are unsure what information can be conveyed to counterparties and other market participants. While it is clear (or at least should be) that disclosing the details of a client’s order book to a counterparty is not acceptable, market participants have noted that there is much less clarity around what level of aggregation, say, is necessary in order to convey market colour appropriately. As a result, it appears some market participants are being very conservative in sharing information, which can have implications for the effective functioning of the market. This is notwithstanding the guidance provided in this area in the Global Preamble put out by the global Foreign Exchange Committees, including the Australian Foreign Exchange Committee (AFXC), in March 2015. 4 The Global Code takes the material in the Global Preamble and fleshes it out a bit more, including with some examples of what is, and isn’t appropriate communication, and why. Similarly, there have been diverse opinions around what is appropriate behaviour in terms of order handling. While there have been some very public instances of inappropriate behaviour around order handling which have come to light in recent years, in other areas, the market is seeking greater guidance as to what principles should be followed, including the different standards that may apply depending on whether an intermediary is functioning as principal or agent. 5 This is one area that was not adequately covered in the pre-existing codes of conduct that the various FXCs had endorsed for the FX market. It is an area where we are aiming to provide the sought-after guidance. But we are not writing a procedures manual for order- http://www.bis.org/about/factmktc/fxwg.htm. http://afxc.rba.gov.au/about-us/pdf/global-preamble.pdf. I am not using these terms in the legal sense that is sometimes the case in particular jurisdictions, but rather in terms of common market parlance. BIS central bankers’ speeches handling. Rather we are articulating principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manual. Our aim in articulating these principles is to provide market participants with the framework in which to think about how they handle stop-loss orders. The emphasis here is very much on the word “think”. The Global Code will not provide the answers to all your questions, but it should help you ask the right questions. In a similar vein, I will repeat a point that I have made a number of times in the past. One of our most central aims in drafting the Code is for it to be principles-based rather than rulesbased. There are a number of reasons why this is so, but for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. If it’s not expressly prohibited or explicitly discouraged, then it must be okay seems to be the historical experience. Moreover, the more prescriptive and the more precise the code is, the less people will think about what they are doing. If it’s principles-based and less prescriptive then, as I just said, market participants will have to think about whether their actions are consistent with the principles of the Code. Adherence to the Code Alongside drafting the Code, we have also been devoting considerable time and effort to thinking about how to ensure widespread adoption of the Global Code by market participants. Clearly, that has been an issue with the various existing codes that have been in place in a number of markets over many years. It is evident that they were ignored on occasion, wilfully or otherwise. As I said earlier, we are working with the industry to produce a principles-based code of conduct rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. But we do expect the principles in the Code to be understood and adopted across the entire FX market. We laid out our overall approach to adherence to the Code in New York last month 6 and we intend to work closely with market participants in the coming year to facilitate the development of market-based mechanisms which demonstrably embed the Global Code within firms’ culture and practices. These mechanisms need to be sensitive to existing law and regulation and to the diverse nature of FX markets globally. Hence a ‘one size fits all’ approach to adherence would not be appropriate. We need to strike the right balance between respecting the existing diversity across different markets, and establishing globally consistent and effective adherence mechanisms. The success of the Global Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. That is why the Global FXCs issued a joint statement of support at the launch of the Code in New York, making clear their intention for the Global Code to become an integral part of the wholesale FX market. 7 Furthermore the BIS central banks signalled their commitment by announcing that they themselves will follow the Code, and that they expect that their counterparties will do so too. 8 Our intention is that the complete Code will be released following the Global Foreign Exchange Committee meeting in London in May 2017. At the end of that process, for the code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed by the FXCs and market participants more generally. http://www.bis.org/mktc/fxwg/am_may16.pdf. http://afxc.rba.gov.au/news/afxc-26052016.html. http://www.bis.org/press/p160526a.htm. BIS central bankers’ speeches That said, the process does not really end, because as the foreign exchange market continues to evolve, the Code will need to evolve with it. I will have more to say about how this ongoing evolution of the Code might occur in due course. Conclusion That, I trust, gives you a reasonable overview of the state of play on the Global Code. A lot of work has been done to get us to this point. There is still a lot of work to be done. The work to date has reflected a very constructive and cooperative effort between the central banks and market participants. All of us recognise the need to restore the public’s faith in the foreign exchange market and the value of the Global Code in assisting that process and also in helping improve market functioning and confidence in how the market functions. I expect that cooperative relationship will continue as we see this process through to its conclusion in May next year. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 6 |
Speech by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Economic Society of Australia (QLD) Business Lunch, Brisbane, 16 June 2016. | Christopher Kent: The economic transition in China Speech by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Economic Society of Australia (QLD) Business Lunch, Brisbane, 16 June 2016. * * * I thank Arianna Cowling, Patrick D’Arcy, Iris Day, Chris Read, Ivan Roberts and Andrew Zurawski for invaluable assistance in preparing these remarks. Introduction I would like to thank the Queensland branch of the Economic Society of Australia for hosting this event. It is a pleasure to be back here to discuss the economic transition in China. This topic is important for the Australian economy, where economic activity is rebalancing toward non-mining sectors following the end of the commodity price boom. Indeed, this process is well advanced. The latest data suggest that non-mining activity is growing a little faster than GDP. Much of the original impetus for the commodity price boom came from the rapid rise in China’s demand for raw materials. Eventually, the global supply of commodities increased, including supply from the resource-rich states of Queensland and Western Australia. In turn, rising supply led to an inevitable decline in commodity prices. Although prices are still well above where they were before the boom, the extent of the decline over the past few years has been larger than most people expected. In part, that reflects an easing in China’s demand for commodities over the past year or two. This has occurred against the backdrop of a moderation in Chinese economic growth more broadly. The slowing in growth had been widely anticipated within China and by outside observers. It is a natural consequence of China moving beyond the rapid phase of growth associated with industrialisation. There is, however, considerable uncertainty and debate around the extent to which imbalances that have become increasingly evident will affect the sustainability of China’s growth over the coming decade. Key concerns are the economy’s reliance on investment as a source of demand and on debt as a source of funding for that investment. Our central forecast, which is similar to those of many observers, is that the Chinese economy will experience a further gradual moderation in growth over the next few years. 1 The Chinese authorities intend to keep overall growth close to its current level for the remainder of the decade. However, there appear to be increasing tensions between the goals of shoring-up short-term growth and pursuing institutional reforms that would help to sustain growth over the longer term and assist with the rebalancing of demand from investment to consumption. The Chinese authorities have an expansive agenda of reforms necessary for this transition and progress has been made on a number of fronts. Even so, major reforms to the financial system needed to improve the allocation of capital and social reforms that would bolster consumption demand remain incomplete. The reform process will take time – as it does in most countries. Note that our forecasts are similar to those of both the International Monetary Fund and Consensus. See, IMF (2016), World Economic Outlook, April 2016. BIS central bankers’ speeches China will continue to provide Australia with significant economic opportunities over the longer term, including in sectors such as agriculture, education, tourism and a wide range of business services. Along the way though, we should be alert to the risk of adverse developments that could lead to a sharp economic slowdown in China. I thought it would be useful to share our thoughts about some of these downside risks. I should stress at the outset that the Chinese authorities are attentive to these risks and have the scope to respond if the economy turns out to be much weaker than expected. How the authorities will respond if those risks come to pass is beyond the scope of my presentation today. But I’ll ask you to keep in mind that the authorities will respond so as to help promote strong and stable growth in China. Let me start with a brief review of China’s development up till now. China’s pattern of development China experienced GDP growth of almost 10 per cent per annum on average over the past 20 years. This resulted in a seven-fold increase in real GDP per capita (Graph 1). Growth of that magnitude is impressive, particularly for such a large economy. Even so, incomes are still well below the levels of advanced economies, including those in the Asian region. So there is substantial room for further development. Graph 1 Key drivers of China’s growth over the past few decades have included industrialisation, urbanisation and favourable demographic trends. A range of other factors have also contributed, including: • entry into the World Trade Organization (WTO) in 2001, underpinning China’s emergence as the largest exporter of manufactured goods • a wave of privatisations for many inefficient state-owned enterprises (SOEs) in the late 1990s • the emergence of private housing markets in the 1990s • and, more recently, policy stimulus undertaken in response to the global financial crisis. The Chinese economy has changed significantly, from one primarily dominated by agriculture, to one driven by the industrial and service sectors. The rapid emergence of China’s industrial economy has been associated with strong investment growth in BIS central bankers’ speeches manufacturing and infrastructure (Graph 2). Even by emerging market economy standards, China’s development has been characterised by very high levels of investment, underpinned by a high and rising rate of household saving (Graph 3). Graph 2 Graph 3 Against this background, the Chinese Government’s stimulus policies adopted amid the global financial crisis led to a boom in debt-funded infrastructure investment and construction of residential and commercial properties. While these policies supported China’s economic activity and promoted urbanisation, they also exacerbated what was arguably an already “unbalanced” pattern of growth and the rise in debt contributed to the emergence of substantial financial risks. BIS central bankers’ speeches Moderating growth in China Despite the stimulus following the global financial crisis, annual growth peaked in 2007 (Graph 4). As an aside, it is worth remembering that while China’s growth is slower than it was 10 years ago, its contribution to global output growth is greater now because the Chinese economy is so much larger than it was. In terms of output, the moderation in growth has been reflected in a slowdown in the industrial sector, while growth in the services sector has been more resilient. At the same time, on the expenditure side of the ledger, investment growth has declined while consumption growth has been relatively persistent. Graph 4 The moderation in the growth of overall activity reflects a combination of longer-term and shorter-term factors. One prominent long-term factor has been the reversal of China’s “demographic dividend”. The working-age population has reached its peak and is in decline. 2 A second persistent factor is the decline in the growth of productivity. 3 Both labour and total factor productivity experienced periods of rapid growth in the 1980s, 1990s and early 2000s following market-oriented reforms and increased openness to trade and investment (Graph 5). Urbanisation also underpinned high rates of productivity growth as people moved from relatively unproductive jobs in agriculture to more productive jobs in cities. However, since the late 2000s productivity growth has declined, as the positive effect of earlier reforms faded. The relaxation of the one-child policy is unlikely to have a substantive effect on population ageing, at least not in the short-to-medium term (Lim J and A Cowling (2016), “China’s Demographic Outlook”, RBA Bulletin, June, pp 35–42.) Some weakness in productivity growth may relate to a cyclical slowing in the industrial sector, whereby producers (particularly SOEs) have held on to labour even though production has declined. BIS central bankers’ speeches Graph 5 As in many other economies, housing demand has been an important driver of China’s growth. Earlier development of private housing markets led to a sharp rise in residential investment (as a share of GDP) from the early 2000s (Graph 6). 4 But the pace of growth in housing investment has declined and has made a relatively modest contribution to Chinese growth of late. Graph 6 The combined direct and indirect share of GDP growth accounted for by housing investment is estimated to have been as high as 30 per cent or so in recent years. See, Ma G, I Roberts and G Kelly (2016), ‘A Rebalancing Chinese Economy: Challenges and International Implications’, Paper presented at the RBA Conference ‘Structural Change in China: Implications for Australia and the World’, Sydney, 17–18 March. BIS central bankers’ speeches One long-term factor affecting housing demand is the slowdown in the growth of the workingage population, which means that China is also passing its peak in household formation. 5 A shorter-term influence is the substantial rise in the stock of unsold housing in a range of smaller cities, as developers built in anticipation of urbanisation that did not materialise as rapidly as expected. It will take time for these inventories to be reduced and for market signals to direct investment to locations with the best prospects for urbanisation. Further urbanisation, and demand for larger and higher-quality housing as Chinese incomes grow, will continue to underpin residential housing demand for some time. But as markets become saturated, housing is likely to become a less powerful engine of Chinese growth. The slowdown in residential property investment over the past few years has affected heavy industries that produce construction materials, including steel. The weakness in demand of late, combined with earlier strength of investment, has led to a rise in excess capacity in a range of manufacturing and mining industries, and widespread deflation in industrial prices. Growth of profits in the industrial sector is now the weakest it has been since the nonperforming loan “crisis” of the late 1990s (Graph 7). Excess capacity in the industrial sector has been associated with the phenomenon of socalled “zombie firms” – enterprises that are making losses but still attracting financial resources. 6 In many cases, these are local government SOEs with substantial social welfare obligations, which leads to understandable resistance to closure. The “supply-side” reform initiative announced by central government authorities late last year has set goals for the closure of excess capacity in coal and steel over the next few years. Graph 7 The working-age population for urban centres has not yet peaked (given ongoing urbanisation), although its growth rate is gradually declining. Also, earlier rapid growth in housing demand was partly a response to unmet demand for private housing that had built up under the old state-dominated housing system. This source of growth was always going to wane, as the backlog has been progressively satisfied. The term has been used publicly by the Premier, Li Keqiang, to describe such firms. For example, see: Keqiang L (2016), Report on the Work of the Government’ available at <http://english.gov.cn/premier/news/2016/03/17/content_281475309417987.htm>, delivered at the Fourth Session of the 12th National People’s Congress of the People’s Republic of China, 5 March. BIS central bankers’ speeches Evidence of poor returns in manufacturing is mirrored in declining returns to investment for the Chinese economy overall. Rough estimates suggest that the return on capital in China has fallen relative to the average cost of finance, largely reflecting a rapid increase in the capital-output ratio since the late 2000s (Graph 8). 7 Graph 8 Prospects for rebalancing In contrast to the weakness in profits, the share of income going to labour now appears to be rising, reversing the decline seen over the past decade. 8 Accordingly, it is reasonable to expect that, over time, the composition of demand will tilt towards consumption and away from investment. Indeed, there are tentative signs that this ‘rebalancing’ may have started in the past few years. However, Chinese consumption growth is already very strong and, historically, it has been rare for economies to experience stable and strong consumption growth during such a rebalancing. In China, as in many economies, investment tends to create sizeable demand for industrial goods, while consumption demand is increasingly focused on services. Thus, a shift in the composition of demand from investment to consumption is likely to be accompanied by resources moving from the capital-intensive industrial sector towards the more labour-intensive services sector. Achieving that in a smooth manner will be a significant challenge. In particular, the move of workers from industry to the services sector is unlikely to be seamless and could pose risks for employment and household income. Any decline in the growth rate of household incomes is likely to pose a risk to consumption. This is because Chinese households are likely to maintain their high rates of saving. 9 In part, that desire reflects the significant gaps in public pension and health insurance systems and incomplete access of many migrant workers to social security. See Ma, Roberts and Kelly (2016). This shift in factor income shares towards labour is a sign that price signals in the Chinese economy are increasingly reflecting the investment-heavy pattern of expenditure mentioned earlier. See Ma, Roberts and Kelly (2016). BIS central bankers’ speeches In short, the limited prospects for stronger consumption growth and the declining returns to investment suggest that the bulk of the rebalancing over coming years is likely to be accomplished through slower investment growth. Other things being equal, this would entail a further easing in growth of activity overall. Competing objectives and rising risks The Chinese authorities acknowledge the challenges posed by the various objectives they have set themselves. A key objective is to double 2010 income levels by 2020. This would require annual average growth of 6.5 per cent over the next few years. 10 By itself, this might prove challenging in the face of unfavourable developments affecting the longer-run determinants of growth. In particular, the prospects for a rapid turnaround in productivity growth would appear to be rather limited given the gradual pace of economic reforms in recent years. But the government has ambitious reform plans, including: • increasing the transparency of local government finances • staged reform of the household registration (hukou) system • increasing the coverage and sustainability of pension schemes and developing a national health insurance safety net • and reforming SOEs, in part through consolidation, to create efficiencies. Some early, but gradual, progress has been evident in these areas. At the same time, the authorities would like to encourage the rebalancing of demand growth away from investment and to slow the accumulation of debt, at least within the heavily indebted corporate sector. However, over recent years meeting short-term growth targets appears to have taken precedence over plans to place growth and financing on a more sustainable footing. 11 This goal was first stated at the 18th National Congress of the Communist Party of China (CPC) and reiterated at the National People’s Congress in March 2016. See Jintao, H, ‘Report of Hu Jintao to the 18th CPC National Congress’ (2012) available at <http://www.china.org.cn/china/18th_cpc_congress/2012– 11/16/content_27137540.htm> and Keqiang, L, ‘Report on the Work of the Government’ (2016) available at <http://online.wsj.com/public/resources/documents/NPC2016_WorkReport_English.pdf>. A recent article in the People’s Daily, the most authoritative official media source, has highlighted that the government faces a dilemma in managing the economy; the article itself can be seen as an attempt by the authorities to manage expectations. See, People’s Daily (2016), ‘An Authoritative Person Discusses the Current Chinese Economy’, 9 May, p 1. Available at <http://paper.people.com.cn/rmrb/html/2016– 05/09/nw.D110000renmrb_20160509_6-01.htm>. BIS central bankers’ speeches Graph 9 Over the past year, meeting the government’s short-term growth goals required policymakers to pursue more stimulatory macroeconomic policies. This has been achieved through cuts to benchmark interest rates, an easing in fiscal policy and a relaxation of housing market restrictions – all while accommodating a faster pace of debt accumulation. 12 Overall, these measures have tended to stimulate investment – in housing and public infrastructure – more so than consumption or private investment. Indeed, there has been a return to growth in housing prices, a pick-up in housing sales and a recovery in residential investment. 13 The trend rise in the ratio of debt to GDP since the global financial crisis has continued. Although estimates vary somewhat, this has led China’s total (public and private) debt to rise to around 250 per cent of GDP (Graph 9). 14 This is still below that of several advanced economies, but it stands out among emerging market economies given China’s relatively modest stage of economic development. The high level and rapid growth of debt in China increases its vulnerability to adverse shocks. Reflecting the investment-driven nature of the expansion since 2008, the rise in debt has been concentrated in the corporate sector and local governments’ off-balance sheet vehicles that have been responsible for funding substantial infrastructure investment. There is a risk that defaults on these debts could impose significant losses on financial institutions and could lead to a general loss of confidence and a tendency for liquidity to recede in a range of funding markets. To date, efforts by policymakers to address risks associated with the build-up in debt have focused on restructuring local government debt. High-interest off-balance sheet funding has been swapped with the issuance of low-interest local government bonds; that is good for local governments but comes at the cost of putting more pressure on banks and other lenders by reducing their interest income. With regard to addressing financial risks in the corporate sector, so far, the central government appears to have taken a relatively hands-off The rate of growth of financing has picked up noticeably (to around 17 per cent in year-ended terms, once the swapping of local government off-balance sheet borrowing for local government bonds has been taken into account). For a few of the largest cities, conditions have strengthened so much that the local authorities have been tightening up measures designed to restrict demand, most notably in Shenzhen and Shanghai. For example, see <http://www.bis.org/statistics/totcredit/tables_f.pdf>. BIS central bankers’ speeches approach, leaving it to banks and local governments to address issues as they arise. The authorities also appear more willing tolerate some defaults in the bond market, which has grown rapidly as a source of funding in the past couple of years. This will help improve the allocation of credit overtime, but this funding channel remains vulnerable to the possibility of a sharp reassessment of risks by lenders. So far, there are no outward signs of distress in the banking system, despite falling profit growth and rising non-performing loans (Graph 10). But the structure of the financial system continues to evolve rapidly, raising concerns about the robustness of the funding position of some of the faster-growing segments of the industry, particularly smaller banks and nonbank financial intermediaries. One concern is that some smaller lenders have large exposures to regions and industries currently experiencing economic hardship. Likewise, institutions involved in complex ‘shadow banking’ transactions could experience problems if a shift of sentiment in funding markets forces these types of activities to be unwound. Graph 10 It is worth noting, however, that compared with many cases of heavily indebted emerging economies that have faced financial problems in the past, China’s debt is largely domestic. A considerable portion of that has arisen from state-owned or controlled financial institutions lending to state-owned or state-controlled enterprises, which to some extent allows the problem to be handled within the official “family”. 15 Moreover, the debt has largely been funded by the household sector, which has sustained a very high rate of saving. Although this does not preclude the possibility of substantial disruption in the financial system, it does provide some leeway for authorities attempting to ensure that the financial system remains liquid. The extent of that leeway will potentially depend on the effectiveness of capital controls. But that is a topic for another time. There is a tension between the government maintaining the smooth functioning of financial markets through implicit guarantees of financial institutions, and the problems of moral hazard and inefficient resource allocation that can result. BIS central bankers’ speeches Conclusions China’s economy has grown at an impressive rate over the past 20–25 years or so. However, growth has moderated over recent years and is projected to ease further as the longer-term drivers of that growth recede. Moreover, the pattern of development has given rise to significant imbalances. High and rising levels of corporate debt in the face of excess capacity and declining profitability suggests a greater risk of corporate defaults, which could ultimately lead to disruption in the financial system. There have been many positive signals from the leadership about improving the sustainability of growth, including recent calls to implement so-called ‘supply-side’ reforms, with a view to facilitating deleveraging in the corporate sector and reducing excess capacity in key industries. Nonetheless, the direction of policy so far has tended towards more, rather than less, accommodative monetary and fiscal settings. To the extent that this represents a re-prioritisation of short-term objectives over longer-term sustainability, it may increase the likelihood of a future disruptive adjustment. Even so, the authorities will no doubt respond if the economy experiences shocks that might otherwise lead to a so called ‘hard landing’ for the economy as a whole. In other words, they are aware of the challenges and have scope to respond if the economy turns out to be much weaker than expected. For Australia, the primary risk posed by the uncertain outlook in China is to commodity prices and the exports of goods (particularly resources) and services. A depreciation of the Australian dollar in response to negative developments in external conditions could be expected to act as a buffer in the way that it has in the past. While I have focused today on a number of the downside risks, we should not lose sight of the fact that the central scenario over the next few years is for a gradual moderation of growth in China. And over the longer term, there is a lot of room for further development of the Chinese economy, which will provide Australia with many economic opportunities. While the value of non-rural exports to China have declined with the fall in commodity prices, the value of other exports to China have been rising strongly of late (Graph 11). We are likely to continue to benefit from rising incomes and the associated demand for high-quality food, goods and a wide array of household and business services from China and the region more broadly. Graph 11 BIS central bankers’ speeches | reserve bank of australia | 2,016 | 6 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the 4th Australian Regulatory Summit, Sydney, 21 June 2016. | Guy Debelle: Liquidity in Australian fixed income markets Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the 4th Australian Regulatory Summit, Sydney, 21 June 2016. * * * Thanks to Jon Cheshire for his work locally and globally on this topic. Fixed income markets in many jurisdictions have been going through a period of change, resulting in a debate as to whether they are continuing to function effectively and, in particular, function effectively in times of stress. Changes in dealer business models and increased use of electronic trading platforms are influencing the nature of liquidity in bond markets. However, these changes are not as prevalent in Australia as they are in some markets overseas, and that is what I am going to talk about today. Globally the debate on bond market liquidity has been ebbing and flowing over the past couple of years. You can hear that it is simultaneously the best of times and the worst of times for liquidity in the bond market. Or to stick with the water analogy that is so prevalent in such discussions, the market is awash with liquidity at the same time as the tide is going out. As an aside, the water references in liquidity discussions are as pervasive as they are in Pixies’ songs. I discussed some of these issues in a speech last year 1 and there have been two recent publications from two BIS Committees that I am a member of that provide a comprehensive account of recent developments in bond market liquidity globally. 2 Rather than recount the global discussion, instead I will try and make it more directly relevant to this audience and run through some of the factors affecting Australian fixed income markets, drawing on work done by my colleague Jon Cheshire published in the RBA Bulletin last week. 3 The assessment that Jon makes, which I share, is that liquidity in most segments of the physical bond market in Australia is lower than it has been in the past. That is, it is generally a little more costly to transact in the same volumes, with immediacy, in the Australian bond markets than it used to be. These changes are partly a response to regulation and partly a reassessment of business models by banks. But, given that liquidity was oversupplied and underpriced in the years prior to the global financial crisis, these changes in liquidity are broadly desirable and, to date, have not presented any significant issues in the Australian market. Measuring liquidity What do we actually mean by bond market liquidity? Often participants in this debate talk at cross purposes using different metrics of liquidity, so let me explain how we are assessing bond market liquidity. Market liquidity is the ability to execute transactions in size, immediately, at low cost and with limited price impact. As you can see, there is both a quantity and time element to liquidity which is often conflated in discussions about it. Debelle G (2015), ‘Bond Market Liquidity, Long-term Rates and China’, Speech at the Actuaries Institute ‘Banking on Change’ Seminar, Sydney, 16 September. Markets Committee (2016), ‘Electronic Trading in Fixed Income Markets’, Markets Committee Publications No 7 Available at <http://www.bis.org/publ/mktc07.htm>, Bank for International Settlements, Basel. CGFS (Committee on the Global Financial System) (2016), ‘Fixed Income Market Liquidity’, CGFS Papers No 55, Bank for International Settlements, Basel Available at <http://www.bis.org/publ/cgfs55.htm>. Jon Cheshire made a significant contribution to both of these papers. Cheshire J (2016), ‘Liquidity in Fixed Income Markets’, RBA Bulletin, June, pp 49–58. BIS central bankers’ speeches Given these different dimensions to liquidity, measuring it precisely is not a straightforward exercise. This is particularly the case in Australia, where much of the secondary market activity is not conducted on electronic platforms and so the trade data is less readily available. It would be good to see more trade data on transactions in the market, although, in saying that, it is possible to have too much transparency in this regard. This is particularly so in a relatively small fixed income market like that in Australia, where the revelation of market participants’ positions in close to real time can be problematic. The first metric I will use to illustrate developments in liquidity is turnover; that is, the quantity dimension. I will discuss the price aspect below. A smaller share of the stock of outstanding bonds is being transacted relative to the past (Graph 1). The turnover ratio (the ratio of the value of transactions undertaken in bond markets over the course of a year relative to the average outstanding stock of bonds on issue over the year) for government bonds has declined from an average of around five in the decade prior to 2012, to a little above three over the past four years. However, over the same time, the supply has grown significantly, so that the absolute amount of turnover hasn’t changed all that much. The turnover ratio of corporate securities has declined to a little above one in the decade prior to 2012 to its current level of about a half. Graph 1 Looking at this another way, the share of the government bond market that used to turnover in an average month now takes a bit over six weeks, while the average share of the corporate securities market that used to turnover in one month now takes closer to two months. We also hear from market participants that it is, in general, a bit more difficult to transact in size. Should we be concerned about this? Not necessarily. The corporate bond market in Australia has never had a highly liquid secondary market. It has always been predominantly a buy and BIS central bankers’ speeches hold market, and most participants are well aware of this. More generally, bond market activity in Australia has been structurally declining over a long period. In the mid 1990s, the turnover ratio for government bonds was around 10, by the late nineties this had fallen to around 7. A decade later in the mid 2000s, it had fallen to around 5 and now it is 3. There are number of explanations for this decline in turnover which I will now turn to. Derivatives Market participants have been increasingly transacting in derivative instruments rather than the cash bonds. Since the mid 1990s, activity in bond futures and interest rate swaps, relative to bonds outstanding, has increased sharply (Graph 2). In 2015, the value of turnover in bond markets was around $A2½ trillion whereas the value of turnover in both the Australian dollar interest rate swaps and bond futures markets was each around $A9 trillion. 4 Growth in activity in these markets in recent years has significantly outpaced growth in issuance of Australian dollar bonds. Overall, the increase in derivative activity has more than offset the decline in bond market activity. Graph 2 These figures are sourced from the AFMA. I’m only referring to interest rate and tenor basis swaps turnover here. BIS central bankers’ speeches There is a clear preference for bond issuers and investors in Australia to manage the risk associated with their bond issuance or bond holdings by transacting in the derivative instruments rather than in the physical instruments. 5 This has resulted in a further concentration of liquidity in the derivative instruments and a decline in liquidity of cash instruments. This development is likely to continue to occur, particularly for less liquid segments of the bond market. This is occurring because these standardised derivative instruments can be significantly cheaper to transact than the physical instruments. One of the reasons for this is simply that a physical transaction has a larger cash component than a derivative transaction. This cash component has to be funded. If the cost of funding is relatively high, market participants are likely to shift activity into other instruments. That said, fixed income derivative markets cannot act as a perfect substitute for bond markets because they are not a funding source for the seller nor do they represent an investment for the buyer. The underlying bonds still have to be issued! Electronic trading The share of derivative market transactions relative to cash transactions is larger in Australia than in European and North American fixed income markets. This presents a challenge for local bond markets to compete for business with the derivative markets. How could this come about? One way is to look to lower the cost of transacting in bond markets. This could happen if a greater share of transactions were conducted via electronic trading platforms. Electronic platforms typically offer a lower cost structure than traditional phone dealing. The share of electronic trading in government bond markets in Australia is around a third. But in European and US bond markets the share of electronic trading is considerably greater at over fifty per cent. In the bond futures markets most trades are conducted via an electronic platform while around 25 per cent of interest rate swap transactions occur via electronic platforms. There appears to be scope for a greater share of trading in Australia’s government bond market, at least, to take place on electronic platforms. The price of liquidity Having talked so far about the stock of liquidity, I will now turn to developments in the price of liquidity. While turnover appears to be lower in bond markets, the price of transacting doesn’t appear to be much different from where it has been in the past. This is apparent from bid-ask spreads, which is a measure of the difference between the price that a buyer is willing to pay for a typical amount of an asset and for which a seller is willing to sell. Bid-ask spreads have been narrowing or are around their narrowest in domestic government bond markets. Part of the explanation is that there has been a decrease in the volume that can be transacted at these spreads, as a consequence of both increased electronic trading and decreased principal-based market-making. So spreads are narrower but how much you can make use of these narrower spreads when trading larger volumes is not so clear, and this is often at the root of the divergence in opinion about the current health of markets. Other measures of the price of liquidity also paint a positive picture. For instance, spreads on risky bonds over government bonds are above levels that prevailed in the years leading up to the financial crisis, but significantly lower than the average or extreme levels seen during the crisis years. Volatility too has been a bit higher in the past six to twelve months, but has not reached levels seen in the crisis. For instance, bond dealers and issuers use exchange for physical transactions to manage interest rate risk. See Cheung B (2014), ‘Trading in Treasury Bond futures Contracts and Bonds in Australia’, RBA Bulletin, September, pp 47−52. BIS central bankers’ speeches One reason why Australian fixed income markets continue to function smoothly is that the derivative markets have been operating effectively. For instance, the market depth (the size of a trade that can be executed for a given trade size) in the futures market appears to be similar to levels that prevailed prior to the financial crisis (Graph 3). As I mentioned, these markets account for the bulk of activity in Australian markets. As such, they play a key role in price discovery and in facilitating a transfer of risk among market participants. While part of the concern in global markets is over a withdrawal of market-making activity from bond markets, it is apparent that this issue has not been as important in Australia for some time. Graph 3 The role of market makers The Australian bond markets still rely relatively significantly on market makers who have a dominant presence in the markets. For instance, according to AFMA data, banks account for around 45 per cent of all trades in the Australian Government Securities (AGS) market, down from around 60 per cent in the decade to 2011. At 45 per cent, banks account for a slightly larger share of transactions in the semis market than they did in the past. Their share of transactions in non-government bond markets has declined slightly from 50 to 45 per cent. While in aggregate, banks are still significantly involved, there have been some shifts in the composition of this activity. Australian bond markets have traditionally had a mix of both local and foreign banks, although the number of institutions involved in the bond markets has ebbed and flowed with the size of markets. There was an increase in participation by foreign banks in 2010 and 2011, partly in response to increased demand from their offshore clients, who sought to capitalise on the strength of fixed income markets in Australia relative to those in other jurisdictions. This led the domestic market to be oversupplied for a while in my opinion. More recently, we have seen some foreign participants leave again as it has become uneconomic for them to continue to provide market-making services. As a result, while bond markets are currently larger, relative to GDP, than in the past, the foreign bank presence is a little smaller than it has been at some times in the past. BIS central bankers’ speeches The decline in the presence of foreign banks reflects both a change in business strategy and, in some cases, the effect of regulations. For many banks operating in Australia, the effect of regulations such as increased capital requirements and the leverage ratio have not been binding on their business models. Nevertheless, just as has happened in the larger fixed income markets offshore, banks operating in Australian bond markets have changed their business models. This has seen a lower level or greater rationing of principal-based marketmaking as a result of a decrease in appetite to warehouse risk, particularly bonds that are not very liquid. This is evident in the bond inventories that banks hold in their trading books. Banks have decreased the stock of non-government bonds they hold in their trading books and increased the share of government bond holdings. This is partly driven by a decrease in willingness to warehouse bonds that do not trade actively in the secondary market. It also reflects the incentives for banks to hold government bonds to satisfy the Liquidity Coverage Ratio (LCR). Banks’ holdings of government bonds have increased to around 30 per cent of the market. The RBA’s judgement is that a greater holding than 30 per cent may impair the functioning of the government bond markets. In coming to that assessment, one of the considerations is the sizeable share of government securities held by offshore investors. In the case of AGS, this currently amounts to more than 60 per cent of the stock. Many of these investors are buy-and-hold investors. They generally do not undertake securities lending. As a result, these bond holdings are not contributing to the liquidity of the market. Hence, a more relevant metric in considering the share of the government bond market that banks can hold to meet the LCR is the stock of bonds held by domestic investors. Last week, the RBA published its latest assessment of the amount of AGS and semis that could be reasonably held by the domestic banks without impairing market functioning. 6 (APRA then sets the aggregate size of the Committed Liquidity Facility as the difference between the LCR requirements of the banks and the amount of AGS and semis that can be reasonably held.) We have maintained the assumption that the domestic banks can reasonably hold a quarter of the stock of AGS and semis in 2017. Foreign banks operating in the local market hold around another 5 per cent of the stock to meet their LCR requirement. So, in total, this remains at 30 per cent. Based on budget projections of the Commonwealth and State governments, we expect that the domestic banks could reasonably hold $220 billion without impairing the market, which would be an increase of $25 billion compared to the holdings in 2016. High frequency trading High-frequency trading is not as prevalent in the domestic bond markets as it is in some markets There are mixed views on the contribution of high-frequency trading to market functioning, particularly in terms of its contribution to flash events in the bond market such as occurred in the US Treasury market on 15 October 2014 and the German “bund tantrum”. 7 See RBA (Reserve Bank of Australia) (2016), ‘The Committed Liquidity Facility’, rba.gov.au site, 16 June. Joint Staff (US Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, US Securities and Exchange Commission, US Commodity Futures Trading Commission) (2015): ‘The U.S. Treasury Market on October 15, 2014’, Joint Staff Report, July. Markets Committee (2016). Available at <https://www.treasury.gov/press-center/press-releases/Documents/Joint_ Staff_Report_Treasury_10–15–2015.pdf>, ‘Electronic Trading in Fixed Income Markets’, Markets Committee Publications No 7, Bank for International Settlements, Basel, January. Available at <http://www.bis.org/publ/mktc07.htm>. See also ASIC (Australian Securities and Investments Commission) (2015), ‘Review of High-Frequency Trading and Dark Liquidity’, Report 452, October. Available at <http://asic.gov.au/regulatory-resources/markets/market-structure/dark-liquidity-and-high-frequency-trading/ review-of-high-frequency-trading-and-dark-liquidity-2015/>. BIS central bankers’ speeches High-frequency trading does not have a presence in the physical bond market while it has a modest presence in the bond futures market, growing to around 15 per cent over the past few years. That said, high-frequency trading activity in the domestic market is often concentrated around particular events, most notably the bond futures rolls. The share of high-frequency trading around the futures roll can be considerably higher. The presence of high-frequency traders can reduce the costs, in terms of spread, of transacting small parcel sizes. There is evidence of that occurring in the domestic market. But, high-frequency trading firms do not hold trading positions for a long period of time. During periods when market prices are adjusting, the presence of market participants that have longer holding periods can be beneficial because these participants absorb some of the order imbalance. One possible concern for the future evolution of the bond market is that high-frequency firms reduce the return to market-making activities in normal (benign) times causing market makers to exit as such activity becomes uneconomic. This reduction in market-making then becomes problematic in more turbulent times exacerbating market disruption. This is a potential development we will be monitoring, although there is no evidence that this has been an issue to date in the local market. Conclusion In conclusion, Australian fixed income markets have continued to function satisfactorily, even while in some overseas markets there has been increased concern about the capacity of such markets to function effectively. As I’ve noted, part of the explanation for the difference is that the withdrawal of dealers from the bond market in Australia has not been as sizeable as it has been elsewhere. Regulatory change has contributed to the reduced capacity in the domestic market, but not to the detriment of market functioning. Indeed, the fact that the price of liquidity now more accurately reflects the cost of providing liquidity is a positive outcome. Another development that has contributed to the satisfactory outcomes in the domestic market is that a large share of market activity is undertaken in derivative markets that don’t rely as much on market-making capacity and are relatively low cost and efficient. It is likely that fixed income markets in Australia will continue to evolve in coming years, which will require market participants to keep adapting. On our side, we will continue to monitor this evolution and its impact on the efficient functioning of the market. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 6 |
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Anika Foundation Luncheon, Sydney, 10 August 2016. | Glenn Stevens: An accounting Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to the Anika Foundation Luncheon, Sydney, 10 August 2016. * * * The Footnotes can be found at the end of the document. I thank Emily Perry for very capable assistance in compiling this and other recent speeches. Summary The speech examines Australia's economic performance over the past decade, as compared with the global economy and Australia's earlier history. It notes that global growth was lower and much more variable in the past ten years than in the preceding decade. Although this meant that the international shocks hitting the Australian economy were larger than previously, Australia's economic outcomes were no more volatile than they had been previously. The inflation target was achieved, the average rate of unemployment was low and the variability of both real GDP and unemployment were if anything slightly lower than in the past. The speech attributes these outcomes to both the economy's improved capacity to adjust and to effective policy frameworks. In particular the speech concludes that the monetary policy framework has helped the Bank to deliver on its mandate through difficult times. The speech goes on to note that, although the economy performed well overall, the average growth rate of real GDP has been lower in the past decade than the one before. Some slowing was inevitable given the earlier decade included a recovery from recession, but even allowing for that real growth has been lower. The speech then examines the reasons for this, both on the demand and supply sides of the economy. Looking ahead, the speech notes the challenges for Australia in securing stronger future growth in the face of adverse demographics. It notes the need for fiscal consolidation but also the limitations faced by monetary policy in generating growth in demand when households already carry considerable debt. On the question of whether inflation targeting remains a suitable framework, the speech argues that the flexibility in Australia's arrangements allow policy makers to make sensible choices in managing deviations of inflation from target, even for reasonably lengthy periods. ******* Thank you for coming out once more to support the Anika Foundation. The Australian Business Economists and Macquarie Securities Australia have been outstanding in their help over the past 10 years. Through their generosity and yours, as well as some remarkably generous individual donations, the Foundation is in a good financial position. The only problem is that while the Foundation is required to donate at least 4 per cent of the fund each year to activities consistent with its charter, it is hard to find assets that earn 4 per cent with acceptably low risk. That, of course, is a sign of the times in which we live. Very, very low interest rates for “safe” assets, and even many “not quite so safe” ones, have persisted for quite a long time now, and may well continue for some time yet. When I gave the first of these addresses 10 years ago, about the conduct of monetary policy, I certainly did not imagine that the world would look like this in 2016. Since this is the last of these addresses I shall deliver, and since in fact it is the last public address I expect to give as Governor, I intend to use it to look back at those 10 years. This will be my account of the Bank's stewardship over that time. BIS central bankers’ speeches Rather than a chronology of events, I will take the approach of looking at average outcomes over decade-long periods, which I think is more useful. I shall conclude with some observations about the future, though these should not be seen in any way as constraining the actions of the Bank under the guidance of my successor.[ 1] The world economy The times have certainly been anything but boring, mainly because of events beyond our shores. Ten years ago, the “Great Stability”, as Lord Mervyn King[ 2] labels it, was about to come to an end in the advanced economies. That period of reduced economic volatility dating from the mid 1980s was associated with macroeconomic outcomes that were remarkably good. But it wasn't a permanent state of the world. In fact, in some ways, that period of stability and confidence could be said to have sown the seeds of its own demise. Low volatility in economic outcomes encouraged under-pricing of risk and a sense that higher leverage was safer for the individual household or firm (or government). But as leverage increased, this left the world financial system and economy more vulnerable when an adverse shock eventually came along. As we know, the international financial crisis was very serious and had major deleterious effects on economic activity in the advanced countries. At the same time, the “China boom” really started to find its legs in the mid 2000s. The associated rise in Australia's terms of trade was something my predecessor had already remarked upon.[ 3] It ultimately went much further than even the optimists a decade ago would have expected. Some of this was due to the financial crisis. As the crisis unfolded in the period from 2007 to 2009, the Chinese economy, which was approaching the time it would experience a structural slowing anyway, decelerated abruptly, as did many other economies. The Chinese authorities responded with a very large stimulus that brought the boom back bigger than ever. This helped global growth recover in 2010 after its 2009 performance, which was the weakest since World War II. This in turn saw Australia's terms of trade rise to the highest sustained level for more than a century. At the peak they were more than 80 per cent above the average level for the preceding hundred years. Of course, nothing is forever and the terms of trade have been falling for about five years now, and are down from the peak by about a third (though they are still about 20 per cent above that very long-run average). Overall, then, the past decade has been a much more volatile time, from the external point of view, than either of the two preceding decades. This is easily demonstrated with some simple metrics for the growth and variability of the world economy, and Australia's terms of trade. The tables show data for four decade-long periods. Global growth has been lower than it was in the “great stability” period, led by much weaker outcomes for the major advanced countries. Those outcomes were in substantial part a legacy of the financial crisis, of course, though other longer-run factors may also have been at work. Global growth would have been weaker still were it not for two factors: emerging market economies as a group did not slow on average; and in addition, their weight in the global economy increased significantly. This change in weights alone added about one-third of a percentage point to the IMF's measure of global growth in GDP in the latest period.[ 4] The world economy has also been much more variable – even more variable than in the late 1970s/early 1980s, a period not fondly remembered by economic policymakers. Inflation among the advanced economies was lower on average, but noticeably more variable.[ 5] As noted above, Australia's terms of trade rose quite a bit in the period of the great stability, then rose even further, and became much more variable, over the past decade. BIS central bankers’ speeches Table 1: Selected Indicators(a) World GDP growth G7 GDP growth Advanced Economies Inflation Australia's Terms of Trade Index; 1976–1986 = 100 Annual Standard Annual Standard Annual Standard Standard Average average deviation average deviation average deviation deviation 3.1 1.4 3.1 1.7 7.6 3.7 100.0 4.9 3.6 0.5 2.8 1.1 3.6 0.9 97.6 6.4 3.9 1.1 2.5 0.8 2.0 0.4 108.2 13.3 3.3 1.8 0.9 2.0 1.7 1.1 164.2 19.0 Per cent 1976–1986 1986–1996 1996–2006 2006–2016 (a) The most recent data for the annual GDP and inflation series are for 2015, and the first time period for the inflation series covers 1979–1986. Time periods used for quarterly terms of trade data are for the decades to: Q3 1986; Q3 1996; Q3 2006; and the 38 quarters to Q1 2016. Standard deviations are calculated from annual growth rates for the GDP and price series and from the quarterly level of the terms of trade. Sources: ABS; IMF; OECD; RBA; Thomson Reuters The Australian economy If the global environment became more complicated and more variable, and if the shocks hitting the economy became larger, it would not be entirely surprising if this resulted in more variability of the Australian economy. But that is not, in fact, what we find. Table 2 presents the relevant data.[ 6] 1976–1986 1986–1996 1996–2006 2006–2016 Table 2: Selected Australian Indicators(a) Per cent Unemployment Headline CPI Underlying Real GDP growth rate Inflation Inflation Annual Standard Standard Annual Standard Annual Standard Average deviation average deviation average deviation average deviation 2.7 1.1 7.2 1.5 9.1 1.0 8.4 0.5 3.4 0.8 8.6 1.6 4.6 0.7 4.5 0.6 3.6 0.6 6.4 1.1 2.5 0.3 2.6 0.2 2.8 0.4 5.3 0.6 2.3 0.5 2.7 0.2 (a) Quarterly data in the table are for the decades to: Q3 1986; Q3 1996; Q3 2006; and the 38 or 39 quarters to the latest available data for 2016. Both price measures exclude tax changes in 1999–2000 and interest charges before the September quarter 1998. Underlying inflation is calculated using the Treasury Underlying Rate of Inflation in the 1976–1986 decade and trimmed mean CPI inflation for subsequent decades. Standard deviations are calculated from quarterly growth rates for the GDP and price series, and from the quarter-average unemployment rate. Sources: ABS; RBA The first feature I want to point out is that the variability of growth, measured here as the standard deviation of the quarterly growth rate of GDP, was, if anything, slightly lower over the past decade than that in the period 1996–2006 and much lower than in preceding decades. Another way of putting this is that Australia has continued to avoid major downturns.[ 7] Second, we have achieved the inflation target. As of late 2007 and for the first half of 2008, it looked like inflation was going to be a material problem. It reached 5 per cent. The Bank's analysis at the time was that the economy was overheating and inflation was rising mainly for that reason. That judgement stands the test of time. The marked change in the path of the BIS central bankers’ speeches global economy in 2008 had a big effect on sentiment in Australia and the course of the economy and prices. Absent that, I suspect we may have had a fair bit more trouble containing inflation. But events being as they were, inflation came down pretty quickly and we have achieved something pretty close to 2½ per cent on average. In fact, we have been achieving the inflation target for over two decades. From 1993 to 2016, a period of 23 years, the average rate of inflation has been 2.5 per cent – as measured by the CPI (and adjusting for the introduction of the GST in 2000). When we began to articulate the target in the early 1990s and talked about achieving “2–3 per cent, on average, over the cycle”, this is the sort of thing we meant. I recall very well how much scepticism we encountered at the time. But the objective has been delivered. The variability of inflation has been a bit higher over the past 10 years than in the preceding decade. This reflects partly the brief period of high inflation in 2007–08, and some big swings in oil and utilities prices over the decade. Still, in the recent period inflation variability has been much reduced from the days prior to the inflation target. Third, the rate of unemployment, on the standard definition, has been lower and less variable over the past 10 years than in the preceding three decades. This is to be expected given that two of the preceding periods included a major recession and the other included a recovery from one. But that is the point. Managing to avoid deep downturns has been a major advantage. It has given us an average unemployment rate “in the fives” and a low variation around that mean. In summary then, we faced a more volatile world than the one of the “great stability” of the previous period. It was a world characterised by massive swings in our terms of trade, and a very serious international financial crisis followed by a deep global recession, not to mention the effects of the adoption of “non-conventional” policies in the major jurisdictions. And yet the Australian economy avoided a major downturn and turned in a performance on economic activity characterised by no more, and on some metrics slightly less, volatility. We have achieved the inflation target and with an average unemployment rate of between 5 and 6 per cent. Had anyone, a decade ago, accurately forecast all the international events and simultaneously predicted that things would turn out in Australia as they have, they would not have been believed. But here we are. No doubt many factors were at work in achieving this. The economy's inherent ability to adapt has been considerably better than in past episodes of large shocks. I think that is a tribute to various reforms over earlier years and the better management of many individual enterprises. Policy frameworks functioned effectively. The exchange rate responded to the external shocks in the way it is supposed to. Prudential supervision was effective. The managements of the most important financial institutions managed to avoid being caught up in a major way in the things that brought so much grief to their counterparts elsewhere in the world. Fiscal policy played a major countercyclical role in the most acute phase of the international downturn (though how much latitude it would have to do that again, if needed, is less clear). And as you would expect, I think that the monetary policy framework has functioned very well. The operation of that framework has involved: • an independent central bank focusing on the medium-term inflation target, taking account of the state of the real economy and the shocks affecting it; • neither neglecting financial stability considerations nor letting them completely dictate monetary policy; • allowing the floating exchange rate to adjust; and, importantly, • realism and a degree of modesty, about what monetary policy can achieve. BIS central bankers’ speeches I think it can be said that, operating this framework and under the guidance of the Board, the Bank has delivered on its mandate through difficult times. Before leaving indicators of overall performance, though, a fourth observation needs to be made, which will frame the forward-looking part of my remarks. The observation is obvious from the numbers in the first column of Table 2: the average rate of economic growth over the past decade has been lower than it was previously. This requires some explanation. To the extent that the economy was growing above its potential rate in the preceding decade, as the spare capacity created by the serious recession in the early 1990s was wound back, some slowing in actual growth was always likely. This could probably account for growth slowing from 3.6 per cent to about the 3 to 3¼ per cent growth that most people assumed, up until recently at least, to be trend or “potential” growth. If one further thinks that, by about 2006– 07, the level of output was probably above the trend level, then one could expect a further slight reduction in average growth over the ensuing period as the level of output came back towards the trend level. But it's unlikely this would account for much more than another tenth of a percentage point of slowing, measured over a 10-year average. That still leaves something – maybe up to a quarter percentage point or so – of slower GDP growth on average to be explained. If we measure it on a per capita basis, the extent of slowing is considerably larger. So what is the explanation? There are likely to be both demand-side and supply-side factors at work. On the demand side, it seems more difficult to generate growth in spending in an economy where households are already carrying significant debt. The real cash rate has been about 140 basis points lower, on average, than in the preceding decade.[ 8] So on that metric monetary policy has been easier. Even achieving the present trajectory of domestic demand that we have, which has left the economy with a bit of spare capacity, has involved some net rise in the ratio of household debt to GDP. On the supply side, overall population growth increased and was its highest in many decades. But growth in the population of people aged 15 to 64 years was slower than overall population growth (see Table 3). This was in contrast to previous decades, when the “15–64” population typically grew as fast as or faster than total population – a “demographic dividend”. The rise in labour force participation that had been seen in the 1980s to the mid 2000s has not, in net terms, continued in recent years. Even if we accept that some of this may have reflected demand-side factors, it is likely that the increasing proportion of “baby boomers” moving into the 65-plus age group has started to dampen the trend in overall participation.[ 9] On top of that, growth in productivity per hour appears to have slowed a little in the 2006–16 period. All this suggests some moderation in potential output growth probably occurred.[ 1 0] These factors individually are not especially large, but together they can explain why overall GDP growth has been lower in the past decade. And they largely explain, I submit, the considerably more marked slowing in growth of real GDP per head of total population. Total population grew faster than the population of people realistically available for work; those working continued the existing trend of working slightly fewer average hours; the growth of their productivity per hour was a bit slower; and the limits of our ability to generate demand in a private sector already carrying a good deal of debt meant we have been a little short of full employment in the most recent few years. The effect of much slower per capita GDP growth was obscured for a period by income effects of the terms of trade boom, but as we know that force has been in reversal for some years now. BIS central bankers’ speeches Real GDP per capita 1976–1986 1986–1996 1996–2006 2006–2016 1.4 2.0 2.4 1.1 Table 3: Additional Australian Indicators(a) Annual average growth, per cent Working-age Real GDP per hour Average hours Total population worked worked population (15–64 years) 1.3 1.7 1.3 −0.2 1.3 1.3 1.7 −0.1 1.2 1.3 1.8 −0.3 1.7 1.4 1.5 −0.5 (a) Quarterly data in the table are for the decades to: Q3 1986; Q3 1996; Q3 2006; and 37–39 quarters to the latest available data. Source: ABS Looking ahead With that assessment of the past, let me turn then, very tentatively, to the future. I have already noted that Australia's trend growth rate has probably slowed a little. The demographic effects that are working to slow it are likely to continue over the coming decades. All of this points to the need not only to calibrate our assumptions about future growth prudently, but also to maximise our efforts in those areas that can lift potential growth. This is not just an academic debate about “reform” among “elite” opinion. It's not just about what a response might be to some theoretical future slowing of growth in living standards. Slower growth is here now and has been for a while. It's surely no coincidence that the path back to budget balance is turning out to be a very long one. At present, very low nominal GDP growth looms large in subduing revenue growth, because of the terms of trade decline. But when the terms of trade stabilise, weaker potential real growth per head of population will still be a problem. Many difficult choices will need to be made along the path of budgetary adjustment. At present, general public debate starts with commitment to the need for reform and for putting public finances on a sustainable medium-term track. But when specific ideas are proposed that will actually make a difference over the medium to long term, the conversation quickly shifts to rather narrow notions of “fairness”, people look to their own positions, the interest groups all come out and the specific proposals often run into the sand. If we think this rather other-worldly discussion will not have to give way to a more hard-nosed conversation, we are kidding ourselves. That will occur should there be a moment of crisis, but it would be better if it occurred before then. In addition, and this may complicate the fiscal discussion, we can't just assume that monetary policy can simply dial up the growth we need. We need some realism here. Through a combination of extraordinary circumstances, the central banking community globally has found itself doing unprecedented things. We in Australia have done fewer such things, but we are connected to the world, and the effects of policies adopted elsewhere condition the policy choices available to us. Although we have not implemented “unconventional policies”, we nonetheless have interest rates at levels lower than any of us have seen before in our lifetimes. Moreover, the “return to normal” at the global level looks like being a very, very slow process. And normal is a different place now. As would be clear from my utterances over the past couple of years, I have serious reservations about the extent of reliance on monetary policy around the world. It isn't that the central banks were wrong to do what they could, it is that what they could do was not enough, and never could be enough, fully to restore demand after a period of recession associated with a very substantial debt build-up. BIS central bankers’ speeches Certainly easy monetary policy can reduce the burden on debtors through the cash flow channel, at the expense of savers. This is probably still expansionary in net terms, though possibly less so than it used to be. But in the end, the most powerful domestic expansionary impetus that comes from low interest rates surely comes when someone, somewhere, has both the balance sheet capacity and the willingness to take on more debt and spend. The problem now is that there is a limit to how much we can expect to achieve by relying on already indebted entities taking on more debt. So for policymakers looking to use low interest rates to boost growth, the question is: which entities, if any, in the economy can accept higher leverage safely? In some countries there may be no safe way of borrowing and spending because debt, both public and private, is just too high. In Australia, gross public debt, for all levels of government, adds up to about 40 per cent of GDP. We are rightly concerned about the future trajectory of this ratio. But gross household debt is three times larger – about 125 per cent of GDP. That is not unmanageable – but nor is it a low number. It's an interesting question which sector would have the greater capacity to take on more debt, in the event that we were to need a big demand stimulus. Let me be clear that I am not advocating an increase in deficit financing of day-to-day government spending. The case for governments being prepared to borrow for the right investment assets – long-lived assets that yield an economic return – does not extend to borrowing to pay pensions, welfare and routine government expenses, other than under the most exceptional circumstances. It remains the case that, over time, the gap in the recurrent budget has to be closed, because rising public debt that is not held against assets will start to be a material problem. The point I am trying to inject here is simply that popular debate in Australia about government debt and how we limit or reduce it seems so often to be conducted while largely ignoring the size of private debt. To outside observers this seems odd. Foreign visitors to the Reserve Bank over the years have tended to raise questions about household debt much more frequently than they have raised questions about government debt. So the way ahead is going to have to involve a rather more nuanced consideration of all these issues. What about the future of inflation targeting? For more than 20 years this framework as we have practised it has delivered the desired degree of price stability and has greatly contributed to overall macroeconomic performance. But some people have asked: is it a framework whose usefulness has now come to an end? All frameworks come under stress sooner or later. Circumstances occur that were not envisaged when the system was put in place. When that happens, frameworks that are inflexible tend to break. The gold standard and countless exchange rate pegs in history are examples. Various fiscal rules in Europe have been “honoured in the breach”. And so on. On the other hand, frameworks that have a degree of flexibility, that can bend with the circumstances but retain their essential integrity, like an aircraft wing in turbulence, stand a reasonable chance of coming through. I think the inflation target as we have operated it has the requisite degree of flexibility. The irony is that when we first started talking about inflation targeting, it was our insistence on that very flexibility that made people think we weren't serious. The 2–3 per cent was not a hardedged band. We were not promising that the Governor would be sacked, or have their salary reduced, if the target was missed. Many critics preferred the hard-edged, electric-fence style targets in vogue elsewhere at the time.[ 11 ] Now, it seems some people are concerned we are too committed. They worry that, in a period of very low inflation, the Bank may do things with monetary policy, in an effort to increase inflation back to the target in short order, that might create more problems than they solve. BIS central bankers’ speeches I can assure you that the Board has been very conscious of that possibility and, accordingly, has proceeded very carefully. Of course we have run some risks from pushing interest rates so low, but then there are always risks in any course of action, including inaction. Our job is not to avoid all risk; it is to balance the various risks. To date, I think we have done that, aided by supervisory and regulatory actions by APRA and ASIC. Moreover, with the whole developed world in such a prolonged period of ultra-low rates, it would have been fanciful to think we were not going to be affected. But in the end, we are living in a world in which the ability of monetary policy alone to boost growth sustainably is very likely to be a good deal more limited than we might wish. I think most people can sense this. So we need realism about how much we can expect monetary policy to do, including pushing inflation up quickly. If it were the case that undershooting the target for a period while achieving reasonable growth was the “least bad” option available, the inflation targeting framework has the requisite degree of flexibility to allow such a course. Conclusion That is all for the future and for others to judge. My time is up. To conclude, over the past decade and in a very volatile world, Australia has achieved the inflation target, avoided a major economic downturn, seen remarkably little variability in real economic activity in the face of enormous shocks, experienced a fairly low average rate of unemployment, and had a stable financial system as well. Looking ahead, challenges remain for Australia, not least sustaining a stronger growth outlook over the longer term. More than adjustments to interest rates will be needed to secure that. The Reserve Bank will, I am confident, go from strength to strength under the leadership of its new Governor. We will be in very good hands. It remains to thank all of you very much for coming to this event, and this series of events, in support of the Anika Foundation. Thank you again to the ABE and Macquarie Securities Australia for their support. I also want to say thank you to many of you here who have been supporters of the Reserve Bank, and of me personally, over the years. There are always critics, but I've found there are many, many more who carry enormous goodwill towards the Bank and want us to succeed for the sake of the country. Quite a number of you here today are among that group. I have appreciated that support more than you can know. Endnotes It is also important to note that these remarks are confined to macroeconomic policies and outcomes. The Reserve Bank does much more than monetary policy and has been active across many fronts over the years. Payments policies, management of the balance sheet, note issue and other areas have all seen major innovation. The interested reader is referred to the succession of Annual Reports for these matters. King M (2016) “The End of Alchemy: Money, Banking and the Future of the Global Economy”, page 6. Macfarlane I.J (2005) “Global Influences on the Australian Economy“, Talk to the Australian Institute of Company Directors, Sydney, 14 June. It says something about the magnitude of the event that it played out during the tenure of two central bank Governors, each of whom were in the role for a decade, and will likely still be an important issue, in the early stages at least, for the next Governor. 4 This exercise uses IMF data to compare average annual growth in world GDP between 2006 and 2015 with what world GDP growth would have been over this period if the weights of “advanced economies” and “emerging and developing economies” had remained unchanged from their averages over the 1996–2006 period. I use inflation for the advanced countries because global inflation data are always affected by a small number of countries that from time to time have very high inflation or hyperinflation. That results in a distorted picture. The data used are the most recent vintages of the data, so that for some of the historical periods they differ from what may have been originally published. Likewise, some of the data for the past two or three years, particularly the GDP data, may further be revised over time. But these are the most up to date figures we have as of today. BIS central bankers’ speeches For the GDP data, the figures are up to the March quarter of 2016 while those for inflation and the unemployment rate are up to the June quarter, so the annual averages are computed by expressing 38 or 39 quarters at an annual rate. There have been some small downturns of course. One had occurred in 2000 and another happened in 2008. Had downturns of the same size occurred with a slightly different quarterly pattern in the statistics, they would have been labelled “recessions” in common discussion. While we like to keep retelling the story about how we didn't have recessions, I fear this risks us making the complacent assumption that we won't have them in future. It would be better to be asking how it was that these downturns were so temporary – and doing what we can to make future downturns like that. To say that does not diminish, however, the fact that this has been a very good run for Australia. Even with the shift in margins between the cash rate and lending rates, real lending rates have been lower by between 70 and 90 basis points on average in the latter period. Had participation rates within age groups moved in the way we have seen but the population age structure been unchanged from where it was in September 2006, simple calculations suggest that the participation rate would have been 1.8 percentage points higher in the June quarter 2016. While over the next few years the ramp up in LNG production will temporarily raise potential GDP growth, demographic factors are likely to hold down potential growth for some years beyond that. I can recall being asked by an IMF official during the mid 1990s whether, if inflation rose above the target, we were prepared to create a recession to get it down again. The implication was that we should be. We insisted on not being obliged to have a recession to shave a few tenths of a percentage point off inflation in a short period. We were not believers in the idea of destroying the world to save it. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 8 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the FX Week Asia conference, Singapore, 31 August 2016. | Guy Debelle: The Global Code of Conduct for the Foreign Exchange Market Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the FX Week Asia conference, Singapore, 31 August 2016. * * * Thank you for having me here today to talk about the Global Code of Conduct for the Foreign Exchange Market. As you may know, Phase 1 of the Code was launched in New York in late May. 1 Today I will reiterate the motivation for the work we are doing on the Global Code, then update you on where we are at with the process and outline the way forward. Why is the work going on? As I have stated on previous occasions, the foreign exchange (FX) industry is suffering from a lack of trust in its functioning. This lack of trust is evident both between participants in the market, but at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. A well-functioning foreign exchange market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Global Code sets out global principles of good practice in the foreign exchange market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to restore confidence and promote the effective functioning of the wholesale FX market. To that end, one of the guiding principles underpinning our work is that the Code should promote a robust, fair, liquid, open, and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. The work to develop the Global Code commenced in May last year, when the Bank for International Settlements (BIS) Governors commissioned a working group of the Markets Committee of the BIS to facilitate the establishment of a single global code of conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the code. 2 There are two important points worth highlighting: first, it’s a single code for the whole industry and second, it’s a global code. It’s covering all of the wholesale FX industry. This is not a code of conduct for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; its breadth is both across the globe and across the whole structure of the industry. The Code is intended to apply to all aspects of the wholesale foreign exchange market. I am chairing this work, with Simon Potter of the Federal Reserve Bank of New York leading the work on developing the code and Chris Salmon of the Bank of England leading the http://www.bis.org/mktc/fxwg/gc_may16.pdf. http://www.bis.org/press/p150511.htm. BIS central bankers’ speeches adherence work. Our Working Group comprises representatives of the central banks of all the major FX centres, drawing on the membership of the Markets Committee which is comprised of heads of the market operations areas of the 15 major currency areas. 3 Given our roles, we are all very much interested in the effective functioning of the FX market. Again, it is very much a global effort reflecting the global nature of the foreign exchange market. This work is also very much a public sector–private sector partnership. In that regard, we are being ably and vigorously supported in this work by a group of market participants, chaired by David Puth, CEO of CLS. The group contains people from all around the world on the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants, drawing from the various Foreign Exchange Committees (FXCs) and beyond. There are a number of members of David’s group which are from Asia, including Singapore. Hence all parts of the market are being involved in the drafting of the code to make sure all perspectives are heard and appropriately reflected. At the outset we decided to split the topics we intend to cover in the Code into two parts. This first phase covers areas such as ethics, information sharing, aspects of execution and confirmation and settlement. The second phase will cover further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. We have made substantial progress in drafting the second phase. It will be circulated for comment to the FXCs in early October. As was the case with the first phase, there will be three opportunities for market participants to provide feedback on the material. We will endeavour to make clear how the feedback provided has been addressed. The intent is for the full Code to be published in May 2017. I will now talk about a couple of the areas that are addressed in the first phase of the Code, which is already in the public domain. In the first phase, topics were covered that the market was looking for guidance on sooner rather than later and that were potentially having an adverse effect on market functioning. One example of this is around information sharing, where many market participants have highlighted that they are unsure what information can be conveyed to counterparties and other market participants. While it is clear (or at least should be) that disclosing the details of a client’s order book to a counterparty is not acceptable, market participants have noted that there is much less clarity around what level of aggregation, say, is necessary in order to convey market colour appropriately. As a result, it appears some market participants are being very conservative in sharing information, which can have implications for the effective functioning of the market. This is notwithstanding the guidance provided in this area in the Global Preamble put out by the global Foreign Exchange Committees, in March 2015. 4 The Global Code takes the material in the Global Preamble and fleshes it out a bit more, including with some examples of what is, and isn’t appropriate communication, and why. There will be more examples provided in the second phase of the Code. Similarly, there have been diverse opinions around what is appropriate behaviour in terms of order handling. While there have been some very public instances of inappropriate behaviour around order handling which have come to light in recent years, in other areas, the market is seeking greater guidance as to what principles should be followed, including the different standards that may apply depending on whether an intermediary is functioning as principal or agent. 5 http://www.bis.org/about/factmktc/fxwg.htm. http://www.rba.gov.au/afxc/about-us/pdf/global-preamble.pdf. I am not using these terms in the legal sense that is sometimes the case in particular jurisdictions, but rather in terms of common market parlance. BIS central bankers’ speeches This is one area that was not adequately covered in the pre-existing codes of conduct that the various FXCs had endorsed for the FX market. It is an area where we are aiming to provide the sought-after guidance. But we are not writing a procedures manual for orderhandling. Rather we are articulating principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manual. Our aim in articulating these principles is to provide market participants with the framework in which to think about how they handle stop-loss orders. The emphasis here is very much on the word “think”. The Global Code will not provide the answers to all your questions, but it should help you ask the right questions. In a similar vein, I will repeat a point that I have made a number of times in the past. One of our most central aims in drafting the Code is for it to be principles-based rather than rulesbased. There are a number of reasons why this is so, but for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. If it’s not expressly prohibited or explicitly discouraged, then it must be okay seems to be the historical experience. Moreover, the more prescriptive and the more precise the code is, the less people will think about what they are doing. If it’s principles-based and less prescriptive then, as I just said, market participants will have to think about whether their actions are consistent with the principles of the Code. Adherence to the Code Alongside drafting the Code, we have also been devoting considerable time and effort to thinking about how to ensure widespread adoption of the Global Code by market participants. Clearly, that has been an issue with the various existing codes that have been in place in a number of markets over many years. It is evident that they were ignored on occasion, wilfully or otherwise. As I said earlier, we are working with the industry to produce a principles-based code of conduct rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. But we do expect the principles in the Code to be understood and adopted across the entire FX market. We laid out our overall approach to adherence to the Code in New York last month 6 and we intend to work closely with market participants in the coming year to facilitate the development of market-based mechanisms which demonstrably embed the Global Code within firms’ culture and practices. These mechanisms need to be sensitive to existing law and regulation and to the diverse nature of FX markets globally. Hence a ‘one size fits all’ approach to adherence would not be appropriate. We need to strike the right balance between respecting the existing diversity across different markets, and establishing globally consistent and effective adherence mechanisms. The success of the Global Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. That is why the Global FXCs issued a joint statement of support at the launch of the Code in New York, making clear their intention for the Global Code to become an integral part of the wholesale FX market. 7 Furthermore the BIS central banks signalled their commitment by announcing that they themselves will follow the Code, and that they expect that their counterparties will do so too. 8 http://www.bis.org/mktc/fxwg/am_may16.pdf. http://afxc.rba.gov.au/news/afxc-26052016.html. http://www.bis.org/press/p160526a.htm. BIS central bankers’ speeches We are also talking to regulators in our various countries as to how they might use the Code in monitoring market conduct. We are on track to complete the Code so that it will be released following the Global Foreign Exchange Committee meeting in London in May 2017. At the end of that process, for the code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed by the FXCs and market participants more generally. That said, the process does not really end, because as the foreign exchange market continues to evolve, the Code will need to evolve with it. Conclusion That, I trust, gives you a reasonable overview of the state of play on the Global Code. A lot of work has been done to get us to this point. There is still work to be done to complete the task. The work to date has reflected a very constructive and cooperative effort between the central banks and market participants. All of us recognise the need to restore the public’s faith in the foreign exchange market and the value of the Global Code in assisting that process and also in helping improve market functioning and confidence in how the market functions. I expect that cooperative relationship will continue as we see this process through to its conclusion in May next year. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 8 |
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at a dinner with members of the Sydney community, Sydney, 6 September 2016. | Philip Lowe: Remarks at a Reserve Bank Board dinner with members of the Sydney community Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, at a dinner with members of the Sydney community, Sydney, 6 September 2016. * * * Good evening. On behalf of the Reserve Bank Board, I would like to warmly welcome you all to this dinner. These dinners, which we hold in all the state capitals, have become one the highlights of our calendar. They provide a fantastic opportunity for us to talk with leaders from the worlds of business, politics, academia and the community sector. So thank you all for taking the time to join us this evening. This particular dinner marks a very special occasion. Earlier today, Glenn Stevens chaired his final – and 110th – meeting of the Reserve Bank Board. As you probably know, Glenn has been the Governor of the RBA for 10 years. Before that he was the Deputy Governor for five years. And before that he was the chief economic advisor to the Board for more than five years. All up, he has attended 215 meetings of the Board over some 20 years. Glenn has also attended and chaired 41 meetings of the Payments System Board. I am delighted that many of the current and former members of both boards who have served under Glenn are here this evening. Given the sheer scale of Glenn’s contribution, it is appropriate to begin this dinner by delivering – on behalf of us all – a few words of tribute to him. After that, and after we have had our entrée, the Treasurer, the Hon. Scott Morrison MP will speak and then Glenn will say a few words. That will bring the formalities to a close and then we will enjoy the rest of the meal and conversation. Many of you may know Glenn personally. Those of you who don’t know him might feel like you do: there are few Australians whose public utterances are so closely scrutinised and so widely covered by our media. But whether you know him personally, or through the media, I am sure you will have formed the same impression of Glenn. That is of an incredibly dedicated servant of the public over a career that spans 36 years, and a man of the highest integrity. Glenn has relentlessly served the interests of the Australian people. He has brought a very high level of analytical rigour to the task. He has exercised an independence of thought that is not always seen in public life. He has patiently explained difficult economic issues to Australians. He has talked to us about the challenges that Australia faces, but also the opportunities we have. In a world where optimism has sometimes been in short supply, he has more than once reminded us that the glass is at least half full. He has been deliberate, logical, thoughtful and measured in his remarks. He has done this all without fear or favour. He is a man of courage, prepared to say things that are true, even when they are not popular. And last – but not least – he helped successfully navigate our economy through the biggest resources boom in a century and a global financial crisis. Glenn, I could pay no higher tribute to you than to say that you have rightfully earned the trust of the Australian people. This was acknowledged a few months ago when you were awarded the Companion of the Order of Australia in the Queen’s Birthday Honours for 2016. An honour, richly deserved. While Glenn’s strengths are many, I doubt he himself would include his comedic skills on the list. Underneath that exterior, though, is a seriously dry sense of humour. I recall only one time when Glenn tried a joke in public. That was in July 2013, when he started a speech by saying ‘As some of you may know, the Reserve Bank Board meeting was in Brisbane BIS central bankers’ speeches yesterday at which we deliberated for a long time … to leave the cash rate unchanged’. The market thought the reference to “a long time” was Glenn’s way of sending a secret message in central bank code that the Board would probably cut interest rates the next month. The exchange rate immediately responded by falling by around a cent. The truth was that Glenn was just drawing attention to the fact that some might think it curious, even humorous, that after all the hype surrounding a meeting of the Reserve Bank Board, we did precisely … nothing. I would have to say that Glenn was not particularly pleased with the media coverage of his comedic efforts that day, as they overshadowed another very thoughtful speech. After this unsuccessful attempt, I don’t recall subsequent efforts at humour in public. A practice I hope to continue. So that is the Glenn you see publicly: a serious and courageous man of the utmost integrity who has dedicated his life to the task of serving the public interest. Of course, much of the time Glenn is not in the public eye. Instead, he is quietly and efficiently running the Reserve Bank. While most people don’t see that, I, and my colleagues, do every day. So I just want to draw your attention to three aspects of that work that speak to the man. The first is Glenn’s dedication to the task. It has not been unusual for him to spend a full day at 65 Martin Place, have an official dinner in the evening and then go home and join an international conference call starting at 11pm to discuss some arcane regulatory issue. And then after getting to bed in the small hours of the morning he is back in the office early to lead our regular morning discussions of overnight developments in global markets. He has put in a herculean effort. The second is Glenn’s relentless commitment to work of the highest standard. At the Reserve Bank we pride ourselves on producing work of the highest quality: whether in our written work or in the way we operate key parts of the national financial infrastructure. Glenn – in his unassuming style – has led the way here. Through his example, he has encouraged us to be the best we can be, and to be worthy of the trust that the public has put in our institution. The third is Glenn’s open and consultative style. As you can imagine, in an institution with lots of economists there are lots of opinions too! Glenn has managed this with great aplomb. He is always ready to listen and to seek out alternative perspectives. He has chaired both the Reserve Bank Board and the Payments System Board in the same way. We have all benefited from his inclusive and consultative manner. In short, what you see externally is what my colleagues and I see internally as well. He is going to be a darn hard act to follow! Before I finish, I also want to acknowledge the contribution of Glenn’s wife, Sue Stevens, who is also here this evening. I know Sue has been a fantastic support to Glenn. Sue has had to endure her husband working very hard and constantly being in the public spotlight. Sue, you have done this with great dignity and quiet grace and you should be immensely proud of what you and your husband have accomplished. Thank you. Finally, could I ask you to be upstanding for a toast. Glenn, on behalf of all of us here tonight, and more importantly, on behalf of the 24 million Australians whom you have served so well, thank you. Glenn Stevens. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 9 |
Remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Asian Development Bank - Institute of Global Finance International Conference, Sydney, 8 September 2016. | Philip Lowe: Remarks to the Asian Development Bank – Institute of Global Finance International Conference Remarks by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the Asian Development Bank – Institute of Global Finance International Conference, Sydney, 8 September 2016. * * * I would like to welcome you all to Sydney to this important conference. It is fantastic to see the Asian Development Bank working so closely with an Australian university, the Institute of Global Finance at the University of New South Wales. It is also very pleasing to see that this collaboration is occurring in this beautiful city. I am sure that you will find this conference stimulating and that you will receive warm hospitality in our city. The title of this conference is long. Ten words: “Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience”. It is also challenging. I say this because just below the surface of these 10 words lies a host of complex and difficult issues. The proper functioning of our modern economies depends on us understanding and addressing these issues as best we can. If we get things wrong here, the outcomes can be really bad: our economies will be more volatile, job security will be less and people’s hardearned savings will be at greater risk. The global financial crisis was a powerful reminder of this. So the issues that we will discuss at this conference really matter. It is appropriate that the discussion is taking place at an international conference, which features distinguished speakers from the region and elsewhere. After all, financial stability is a global issue: instability in one country can ripple right around the world. And many of the reforms to address instability are best accomplished internationally. We can also learn a lot from one another’s experiences. In my remarks this morning I would like to highlight three specific questions that are suggested to me by the conference title and papers. These questions are: i. How can we make our financial systems more resilient, particularly in a world in which capital flows easily across borders? ii. How should we characterise and respond to episodes of financial boom and bust – the financial cycle? iii. What determines the amount of systemic risk we are exposed to, and how can we identify and analyse it? The positive news is that in each of these three areas much has been learnt since the crisis. The not-so-positive news is that our answers to these questions are still incomplete and, just as one issue is resolved, too often another seems to emerge. I would like to reflect on each of these three questions, highlighting the progress that has been made and offering a few thoughts on some of the work that remains. Resilience First, to the issue of resilience. Looking back at the experience of the past 20 years, I am struck by the fact that large financial disturbances are repeatedly caused by the same factors. Three stand out: i. poor asset quality, particularly in the area of commercial property development ii. inadequate attention to liquidity management iii. the build-up of unhedged foreign currency exposures. BIS central bankers’ speeches Not surprisingly then, it is these areas that have received the most attention from the international regulatory community. Over recent years, the most extensive of the global reforms has been the Basel III package. This package means that, globally, banks now have more and better-quality capital, so they are better placed to absorb losses. In addition, minimum standards for banks’ liquidity management are now more rigorous and transparent. The stronger liquidity standards also help reduce vulnerabilities from foreign currency exposures, by giving supervisors new ways of monitoring liquidity requirements on a percurrency basis. Other reforms have helped increase resilience in other parts of the financial system, including derivative markets and shadow banking. But the reforms remain incomplete and challenges remain. The last chapter of the Basel III package is being finalised this year. While some of the reforms have helped address the toobig-to-fail problem, there are still considerable challenges in developing recovery and resolution plans for the largest global financial institutions. And, in the area of over-thecounter (OTC) derivatives market reform, legal restrictions sometimes still make it difficult to share information across borders. The Basel Committee and the Financial Stability Board are both reviewing the overall calibration of the reforms. This is essential because with so many new metrics and requirements, we need to ensure they do not interact in unintended ways. Of course, some of the effects that market participants comment on are intended. Maturity transformation has become more expensive. So too, has providing market making services in some financial instruments, generating concerns about a lack of liquidity in bond markets. More broadly, the cost of many forms of financial intermediation across banks’ balance sheets has become more expensive. The promised benefit of this additional expense is that the system is now more stable. But we need to keep an eye on this trade-off, because a well-functioning system needs to be able to take risk at a reasonable price. A well-functioning system also needs to be resilient to the shifting flows of capital across borders. Collectively, global investors can deploy funds on a much larger scale than many markets can absorb without large price movements. In some countries this has led to discomfort with the free flow of capital. But at the same time, access to foreign capital can help drive prosperity and economic development, and allows people to hold more diversified portfolios. The challenge we face then is to design arrangements that allow us to all capture the considerable benefits that open capital markets can deliver, while minimising the attendant risks. The work on the global financial safety net being undertaken in international policy circles is an important contribution here. One of the questions still to be resolved is how extensive that safety net should be and what form it should take. The financial cycle An important theme of this conference is that of “financial cycles”. Identifying and understanding these cycles has become an active area both for academic research and policy development. As a concept, the financial cycle has considerable intuitive appeal. It has long been observed that financial systems seem to be subject to boom–bust dynamics. We have repeatedly seen credit and leverage build up over time in response to some initial impetus, only to generate excesses that ultimately unwind, sometimes painfully. One question we face is how to define and measure these cycles. It has become common practice to start by looking at cycles in credit growth. But there are limitations here. Not all credit cycles end in a financial crisis; indeed in industrialised economies, only a minority have done so. And in some cases a period of fast credit growth, followed by a period of slower growth, might be exactly what is required, and so should not be viewed as problematic. BIS central bankers’ speeches This means that we need to move beyond a focus on credit only. In my view, it is probably more useful to start with the question: are balance sheets in the economy being strengthened or weakened? If credit is growing quickly, we need to think about whether the credit is being used to create new productive assets or simply to finance current consumption. The implications are quite different. A protracted period of balance sheet weakening might reasonably be viewed as problematic, particularly if it increases the probability of future balance sheet strains and weak economic growth. So a research challenge here is to find ways of systematically measuring the quality of balance sheets across the economy, taking into account the myriad influences that are at work. Close analysis and good judgement are both needed to do this. A related research question is how policy should respond to a systematic weakening of balance sheets. This question is the subject of a lot of research at present, much of it prompted by work at the Bank for International Settlements (BIS). The work at the BIS, though it has focused heavily on aggregate credit as the indicator, has advanced the hypothesis that, in some circumstances, the build-up of financial imbalances may be a better guide to the sustainability of growth in the economy than is the current rate of inflation. Clearly, this hypothesis needs to be tested. If it were found to be valid, it would have implications for policymakers in a number of spheres, including monetary policy, prudential policy and even fiscal policy. Systemic risk: interconnections and spillovers Systemic risk is another theme of the conference, and again, a topic inspiring a great deal of academic research, some of which is being presented at this conference. Systemic risk cannot be seen, nor can it be easily measured. So we need to explore a range of indicators. Academic research is helping ensure that we are looking at the right ones. The aspect of systemic risk that I would like to highlight is the interconnections between banks, firms and countries that lie at the heart of the contagion that can turn a small disruption into something much bigger. In the global financial crisis, when one entity became distressed their counterparties incurred mark-to-market losses on the value of securities issued by that entity. Investors also often started refusing to deal with those counterparties that had – or merely were thought to have – significant exposures to that entity. So, contagion could and did occur because of both direct and supposed interconnections. It can occur even as a reputational effect when two entities or economies are perceived to be similar: once investors have reassessed the risks in one institution or country, they often start to probe similar vulnerabilities elsewhere. We cannot escape the conclusion that greater interconnection is a prominent marker of increased systemic risk. The global policy response to the financial crisis has recognised the importance of interconnections and built that into the design of regulatory reforms. Some of the design details are quite technical, but their essence is to create incentives against excessive interconnected exposures between banks, or between banks and other parts of the financial system such as so-called “shadow banking”. Contagion is most likely to occur when information is not equally available to all parties. Opacity and a lack of information about exposures were endemic to OTC derivative markets during the crisis, making these markets an important locus of contagion. Following the postcrisis reforms, derivative markets have functioned more effectively. Regulatory mandates and supervisory incentives are resulting in a larger share of derivatives transactions being cleared through central counterparties and more are being collateralised and are therefore safer. Policymakers also have more visibility about financial market infrastructures now that they play a more central role in financial markets. There are, though, some informationsharing issues in this area that still need to be worked out. BIS central bankers’ speeches One other outstanding issue is how the multiplicity of indicators of systemic risk can inform policymaking, and how one might use the signal provided by an indicator to develop a particular policy response. This is no easy task. The insights of research such as the work presented at this conference will certainly be welcome. Conclusion: the role of supervision In all three areas I have spoken about – namely, resilience, the financial cycle and systemic risk – it is easy to focus mainly on the regulatory initiatives. Regulation can be printed, measured and enforced. But history teaches that regulation cannot solve all problems. The financial system evolves, so no set of rules can deal with all risks and problems. This is an important reason why there needs to be a parallel focus on strong and effective supervision. My view is that a strengthening of supervision is at least as important as are the post-crisis regulatory reforms. Rigorous, inquiring supervision that takes a holistic view of the environment is essential to maintaining financial stability and good outcomes for consumers. I encourage you to consider how the research agenda can be expanded to consider how to best balance regulation and supervision. Thank you for your attention. I wish you the best as you grapple with this difficult set of issues over the next couple of days. BIS central bankers’ speeches | reserve bank of australia | 2,016 | 9 |
Speech by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Bloomberg Breakfast, Sydney, 13 September 2016. | Christopher Kent: After the boom Speech by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Bloomberg Breakfast, Sydney, 13 September 2016. * * * Introduction Today I want to talk about some important developments shaping the Australian economy, focusing on the sharp fall in commodity prices over the past few years. In 2012, just after taking on my current role, some colleagues and I were looking at how the Australian economy had been adjusting to the unprecedented boom in commodity prices.1 By the time I presented that work, prices of Australia’s key commodities had begun to turn down and mining investment had just peaked at a record level.2 Since then, commodity prices have fallen much further and so Australia’s terms of trade (the price of our exports relative to imports) have fallen significantly. The fall was more than we, and most others, had expected. More recently, though, commodity prices have risen. And more than three-quarters of the anticipated decline in mining investment is now behind us. The adjustment of the economy to the decline in the terms of trade and the large fall in mining investment has been a drawn out process, adversely affecting a range of industries and regions. But growth in the economy overall has been close to trend, and while the unemployment rate rose, it reached only a little above 6 per cent in 2015.3 More recently, inflation has declined. Before talking about the period after the boom, I want to set the scene. First, I’ll briefly review the boom years. Second, I’ll describe what we anticipated four years ago would be likely to happen after the boom. The Boom Years The rapid industrialisation and urbanisation of the Chinese economy underpinned the strong rise in commodity prices from around the mid 2000s. As global demand for commodities began to outstrip supply, the prices of Australia’s key commodity exports rose dramatically. Australia’s terms of trade rose by 85 per cent from the average of the early 2000s to the peak in late 2011 (Graph 1). That implied a significant boost to the real purchasing power of domestic production. Some of those gains were retained by foreign owners of mining assets, but a share of the gains stayed at home in the form of higher wages, tax revenues and profits for Australian owners of mines and of firms supporting mining activity. 1 / 16 BIS Central Banker's Speeches The rise in Australia’s terms of trade was associated with a large appreciation of the nominal exchange rate (see Table 1 in the Appendix). While this lowered the returns to Australian commodity exporters (and Australian exporters more broadly), it allowed real income gains to flow to the rest of the economy via the associated decline in the prices of imports. The resource sector here and abroad responded to the commodity price boom by expanding productive capacity. This occurred gradually, reflecting both the unforeseen magnitude of the boom, its unexpected persistence, and the time required to plan for, approve and then complete large resource projects. In mid 2012, investment in the Australian resource sector had peaked at just under 8 per cent of GDP, compared with its average of around 2 per cent prior to the boom. In the lead-up to that investment peak, growth in output, employment and wages in the resource sector (broadly defined to include those industries servicing it) was relatively strong. The boom in those industries led to strong economic conditions in the resource-rich states of Western Australia and Queensland. The significant appreciation of the exchange rate provided a signal for labour and capital to be redistributed from the ‘other tradable’ sector towards the resource sector. As a result, the growth in investment, output, employment and wages was weak in the ‘other tradable’ sector. The large nominal exchange rate appreciation also helped to contain inflationary pressures in an environment of strong growth in domestic demand and a decline in the unemployment rate to relatively low levels. Notwithstanding that assistance, overall inflation picked up to be a little above 2 / 16 BIS Central Banker's Speeches its inflation-targeting average.4 Non-tradable inflation was elevated during the boom years and growth in nominal unit labour costs was relatively strong for most of this period. In response to these inflationary pressures, the Reserve Bank raised the cash rate to be above its (inflationtargeting) average. After the Boom – What We Had Thought Might Happen In our previous analysis, we noted that during the commodity price boom the economy had behaved, in many respects, as theory suggested. We also discussed how the economy might adjust as the terms of trade declined. It was clear that mining investment would fall, but at the same time, resource exports would increase as additional productive capacity came on line. However, overall demand for labour in the mining sector (and in mining-related activity) would decline because the investment phase in that sector is relatively more labour intensive than the production phase.5 With the global supply of commodities catching up to global demand, we thought that commodity prices and, therefore, Australia’s terms of trade would decline (but remain higher than their preboom levels). That would normally be associated with a depreciation of the Australian dollar. We anticipated that demand in the non-mining sectors would pick up and that labour and capital would be drawn back to that part of the economy. Any depreciation of the nominal exchange rate would facilitate that transition by improving the competitiveness of the ‘other tradable’ sector. The movement of labour would also be facilitated by some decline in wage growth, as the labour shed by companies that had undertaken the mining investment looked to move back into the nonmining sectors. In other words, we thought that the requisite real exchange rate depreciation would occur largely via the nominal exchange rate, but might also be assisted by a decline in domestic cost pressures. These developments were expected, at least in part, to reverse some of the effects on consumer price inflation seen during the investment phase of the boom. In particular, a gradual depreciation of the exchange rate would put upward pressure on tradable inflation for a time, while a reduction in wage growth and domestic costs more generally would put downward pressure on nontradable inflation. These opposing effects could potentially result in little net change to overall inflation, but given that inflation had been above average during the boom, it would not be surprising to see inflation below average after the boom. But having made some predictions about the direction of some key variables, we also noted the considerable degree of uncertainty, including that related to the global economic outlook. After the Boom – What Actually Happened? Many of our predictions have been borne out. Mining investment declined significantly and resource exports grew strongly. Mining investment has further to fall, although the largest drag on GDP growth from that source is likely to have come and gone over the financial year just passed. The decline in mining investment from 2012 led to lower growth in overall mining activity (mining investment plus resource exports; Graph 2). More recently, growth of mining activity has picked up. Mining activity is set to continue to grow for a time as the drag from mining investment wanes and production of liquefied natural gas continues to ramp up. 3 / 16 BIS Central Banker's Speeches As had been anticipated, mining-related employment has contracted and wage growth in those industries has declined to be noticeably below that of other sectors.6 In the non-mining sector, growth in activity and employment (more recently) have picked up. The reduction in interest rates over the past few years has been assisting in rebalancing activity towards the non-mining economy, which is currently growing at around its long-run average rate (Graph 3). The depreciation of the nominal exchange rate since early 2013 has also supported activity in the ‘other tradable’ sector. Net service exports have made a noticeable contribution to GDP growth over the past few years, with tourism, education and business service exports all expanding. 4 / 16 BIS Central Banker's Speeches Overall, inflation has declined, driven by lower inflation of non-tradable items and consistent with a significant decline in the growth of labour costs. At the same time, inflation of tradable items has increased following the exchange rate depreciation. In short, the patterns of behaviour of these key macroeconomic variables have been quite consistent with what we had initially thought might happen. However, the magnitudes and speed of some of the adjustments have surprised us. In part, this reflects external developments, most notably: the larger-than-expected decline in commodity prices and the terms of trade; and the extent and persistence of low growth and low inflation in much of the world and the associated easy monetary policies of the major central banks. Despite these challenges, the Australian economy has displayed a degree of flexibility that has helped the process of adjustment. Commodity Prices and the Terms of Trade Australia’s terms of trade declined by more than had been expected a few years ago (Graph 4). Around the time of our previous analysis, we were forecasting a further decline in the terms of trade over the coming years. But then from 2012 to 2015, we repeatedly revised down our forecasts. 5 / 16 BIS Central Banker's Speeches The larger-than-expected decline in Australia’s terms of trade reflected both demand- and supply-side factors. Growth in the demand for commodities from Asia, and China in particular, declined noticeably. In large part, this was in response to excess capacity in manufacturing as well as a decline in real estate investment in China. Among other things, this has seen the growth in global steel production stall, and hence lower growth in the demand for iron ore and coking coal. On the supply side, commodity producers have been able to reduce their costs by more than initially thought possible, and some higher-cost suppliers sustained their production levels for longer than anticipated.7 The larger-than-expected decline in the terms of trade has weighed on growth in economic activity, employment, profits, wages and fiscal revenues, as well as on inflation. The effect has been largest in the mining sector and the key mining states, but it has been evident across the economy more broadly. The Exchange Rate The depreciation of the Australian dollar over recent years has improved Australia’s competiveness and thereby supported production in the tradable sector. However, the depreciation didn’t start in earnest until 18 months after the terms of trade had peaked. And while it is hard to be precise, our modelling suggests that the exchange rate (the real trade weighted 6 / 16 BIS Central Banker's Speeches index, or real TWI) has not depreciated by quite as much as might have been expected in response to the actual decline in the terms of trade (and the reductions in domestic interest rates) (Graph 5). At least in part, this reflects lower-than-expected global growth and inflation, which has led to a prolonged period of very low interest rates and unconventional monetary policies in the major economies.8 Real GDP Australia’s real GDP did not increase by quite as much as we had expected back in late 2012. The GDP forecast in the August 2012 Statement on Monetary Policy was a bit over 1 percentage point stronger than what came to pass over the year to March 2013 (Graph 6). We subsequently revised down our forecasts. In the intervening years growth was sometimes a little above our forecasts, sometimes below. GDP growth more recently has been a bit stronger than we’d expected a year ago. 7 / 16 BIS Central Banker's Speeches Much of the early forecast miss for GDP growth owed to mining investment. In late 2012, we had forecast that mining investment would be likely to rise a little further and stay elevated for a time (Graph 7). It soon became apparent, however, that mining companies had revised their earlier plans in response to lower-than-expected commodity prices. We revised down our forecasts accordingly. Since 2013, our liaison efforts have been instrumental in generating quite accurate forecasts for mining investment. The forecasts for resource exports have also been reasonably accurate over recent years. 8 / 16 BIS Central Banker's Speeches Since 2012, growth in real non-mining activity has picked up gradually and has generally been a little stronger than was expected, supported by lower interest rates and the depreciation of the exchange rate.9 Nominal GDP The weaker than earlier expected outcome for real GDP growth was not particularly large in comparison with the usual range of forecast uncertainty, and as I noted, real GDP growth over the past year has actually been a bit stronger than earlier anticipated. In contrast, the larger-thanexpected decline in the terms of trade over the past few years has meant that nominal outcomes have been significantly weaker than earlier forecast. From 2013 to 2015, nominal GDP increased by around 8 per cent, which was half the initial forecast of 17 per cent. That has had important 9 / 16 BIS Central Banker's Speeches implications for growth in wages, costs and prices. Labour and Labour Costs Given that real GDP growth was initially a bit weaker than expected, it’s not surprising that employment growth was less than forecast and the unemployment rate higher than expected (Graph 8). More recently, however, the unemployment rate has declined by a bit more than had been anticipated.10 Shortly after the fall in the terms of trade, wage growth declined significantly across every industry and all states. It is currently lowest in Western Australia and Queensland, and in industries exposed to the end of the mining investment boom (Graph 9). Some decline in wage growth in response to the decline in mining investment and the terms of trade was to be expected, but the decline in wage growth has been greater than implied by historical relationships with the unemployment rate. That could reflect several factors:11 Workers who had been engaged in mining-related activities moved to lower paid jobs outside the resource sector. This compositional effect contributed to lower growth in average earnings per hour than in the wage price index (at least until very recently).12 Compared with earlier periods of high unemployment rates (e.g. in the 1980s and 1990s), increased labour market flexibility may have provided firms with greater scope to adjust wages in response to declines in the growth of their nominal revenues (which, in turn, followed from the fall in the terms of trade). 10 / 16 BIS Central Banker's Speeches Workers may be less certain of their employment prospects, possibly because of rising competitive pressures in a more globalised world, leading them to be more willing to accept lower wage outcomes in exchange for more job security. The decline in inflation and inflation expectations over recent years may also have influenced wage negotiations. It is important to note that low growth in labour costs has, in many respects, helped the economy adjust to the lower terms of trade. In addition to the nominal exchange rate depreciation, low growth in labour costs is helping to improve Australia’s international competitiveness and has encouraged more employment growth than would otherwise have occurred. More recently, wage growth has shown signs of stabilisation, with growth in the private sector wage price index unchanged for the past six quarters, while a broader measure of wage pressures, the growth in average earnings per hour, has picked up of late. Other Costs and Margins Spare capacity in a range of product markets also led to downward pressure on other costs and margins along the supply chain. This sort of pressure is particularly evident in low inflation of final retail prices for items sold in supermarkets and for many consumer durable goods.13 11 / 16 BIS Central Banker's Speeches Inflation Lower growth in labour and other costs, as well as lower margins, have contributed to lowerthan-expected outcomes for inflation of both non-tradable and tradable items. Compared with earlier forecasts for 2013–2015, inflation in underlying terms has only been a little below expectations (7.1 per cent versus 7.8 per cent cumulated over that period). However, inflation has also been lower than expected more recently; our forecasts for 2016 have been revised down from a bit above 2 per cent to about 1½ per cent between February and August of this year. Interest Rates The initial misses on GDP and unemployment, and more recently on wage growth and inflation, owed significantly to the effects of the larger-than-expected decline in the terms of trade on the mining sector and the economy more broadly. In response to the evolving outlook, the Reserve Bank Board has reduced the cash rate to low levels to improve the prospects for sustainable growth in the economy, with inflation rising to be consistent with the medium-term target. The low level of interest rates and the depreciation of the exchange rate have underpinned a rise in the growth of non-mining activity, which is currently running around its long-run average. Western Australia and Queensland have been most directly affected by the fall in commodity prices and mining investment, and so economic conditions there are still relatively weak (Graph 10). However, New South Wales and Victoria have been less affected by those pressures and so low interest rates and the lower exchange rate have led to an improvement in economic conditions in those states. 12 / 16 BIS Central Banker's Speeches Conclusion The pattern of adjustment of the Australian economy to the decline in the terms of trade and mining investment is generally consistent with what we had anticipated. However, the decline in the terms of trade was larger than expected. In response, there has been significant adjustment in a range of market ‘prices’ – including wages and the nominal exchange rate, although the exchange rate has depreciated a little less than otherwise given global developments. Monetary policy has also responded, with interest rates reduced to low levels. So while mining investment and nominal GDP growth have both been weaker than the forecasts of a few years ago and, more recently, inflation has been a bit weaker than expected, growth in the non-mining economy has picked up and been a bit better than earlier anticipated. Indeed, of late, real GDP growth has been a bit stronger and the unemployment rate a little lower than earlier forecast. In many respects, the adjustment to the decline in mining investment and the terms of trade has proceeded relatively smoothly. The Australian economy has performed well compared to other advanced economies (Graph 11). Moreover, the drag on growth from declining mining investment is now waning and the terms of trade are forecast to remain around their current levels. 13 / 16 BIS Central Banker's Speeches Of course our forecasts are subject to the usual range of uncertainty. But, given that commodity prices have increased substantially over the course of this year, some stability in the terms of trade from here on seems more plausible than it has for some time. Developments in China are likely to continue to have an important influence on commodity prices, given China’s role as both a major producer and consumer of many commodities. For this reason the outlook for the Chinese economy is a key source of uncertainty for the Australian economy. If commodity prices were to stabilise around current levels, that would be a marked change from recent years. Also, the end of the fall in mining investment is coming into view. The abatement of those two substantial headwinds suggests that there is a reasonable prospect of sustaining growth in economic activity, which would support a further gradual decline in the unemployment rate. There is also a good prospect that the growth in wages and the rate of inflation will gradually lift over the period ahead. That’s what’s implied by our central forecasts. Thank you. I’d be happy to take a few questions. 14 / 16 BIS Central Banker's Speeches Appendix 15 / 16 BIS Central Banker's Speeches 1 This was published in early 2013. See Plumb M, C Kent and J Bishop (2013), ‘Implications for the Australian Economy of Strong Growth in Asia’, RBA Research Discussion Paper No 2013–03. 2 Speech delivered to the joint IMF/Treasury/RBA conference on ‘Structural Change and the Rise of Asia’, Canberra, 2012. For other work done on this topic by RBA staff, see: Jääskelä J and P Smith (2013), ‘Terms of Trade Shocks: What Are They and What Do They Do?’, Economic Record 89, pp 145–159; Downes P, K Hanslow and P Tulip (2014), ‘The Effect of the Mining Boom on the Australian Economy’, RBA Research Discussion Paper No 2014–08; Kulish M and D Rees (2015), ‘Unprecedented Changes in the Terms of Trade’, RBA Research Discussion Paper No 2015–11; and Manalo, J, D Perera and D Rees (2015), ‘Exchange Rate Movements and the Australian Economy’, Economic Modelling (47), pp 53–62. 3 The economic adjustment this time around stands in contrast to previous terms of trade booms in Australia, which – despite being smaller than the recent boom – tended to end in sharp contractions in economic activity and large increases in unemployment. See: Battellino R (2010), ‘Mining Booms and the Australian Economy’, RBA Bulletin, March, pp 63–69; and Atkin T, M Caputo, T Robinson and H Wang (2014), ‘ Macroeconomic Consequences of Terms of Trade Episodes, Past and Present’, RBA Research Discussion Paper No 2014–01. 4 Inflation peaked at 5 per cent in late 2008, but declined as economic conditions moderated during the global financial crisis. Growth in nominal unit labour costs also eased during the financial crisis, but rebounded to a peak of around 7 per cent in year-ended terms in early 2011. 5 Even so, labour demand in the resource sector would still remain somewhat higher than it was prior to the terms of trade boom, given the operational needs associated with producing more output. 6 Nevertheless, as anticipated, employment in the resource sector remains higher than pre-boom levels as production of resource commodities has increased. 7 For a discussion of the costs of producing iron ore, see: <www.rba.gov.au/publications/smp/boxes/2015/feb/a.pdf>. The decline in Australian producers’ costs would have supported their profitability, but the decline in the costs of offshore producers would have allowed them to keep producing more than otherwise, and this extra supply would have weighed on commodity prices and, hence, the profits of Australian resource producers. 8 See Hambur J, L Cockerell, C Potter, P Smith and M Wright (2015), ‘Modelling the Australian Dollar’, RBA Research Discussion Paper 2015–12. 9 The improved growth in non-mining activity has occurred despite non-mining business investment remaining subdued. Weakness in non-mining business investment has been most evident in Western Australia and, to a lesser extent, Queensland, where the decline in mining investment and commodity prices have contributed to weak conditions in those states more broadly. More recently, non-mining investment appears to have increased in New South Wales and Victoria, where economic conditions have been improving. 10 There has also been some decline in population growth, most notably in Western Australia. 11 See Jacobs D and A Rush (2015), ‘Why Is Wage Growth So Low?’, RBA Bulletin, June, pp 9–18. 12 For a discussion of the differences between these <www.rba.gov.au/publications/smp/2016/aug/price-and-wage-developments.html>. measures, see: 13 See Ballantyne A and S Langcake (2016), ‘Why Has Retail Inflation Been So Low?’, RBA Bulletin, June, pp 9–17. 16 / 16 BIS Central Banker's Speeches | reserve bank of australia | 2,016 | 9 |
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the TradeTech FX, London, 14 September 2016. | Guy Debelle: The Global Code of Conduct for the Foreign Exchange Market Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, at the TradeTech FX, London, 14 September 2016. * * * Thank you for having me here today to talk about the Global Code of Conduct for the Foreign Exchange Market. As I hope most of you know, Phase 1 of the Code was launched in New York in late May.1 The Code is pretty easy to find. It is available on the JSC website or via the Bank for International Settlements (BIS) website. Today I will reiterate the motivation for the work we are doing on the Global Code, then update you on where we are at with the process and outline the way forward. Why is the work going on? As I have stated on previous occasions, the foreign exchange (FX) industry is suffering from a lack of trust in its functioning. This lack of trust is evident both between participants in the market, and at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. A well-functioning foreign exchange market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Global Code sets out global principles of good practice in the foreign exchange market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to restore confidence and promote the effective functioning of the wholesale FX market. To that end, one of the guiding principles underpinning our work is that the Code should promote a robust, fair, liquid, open, and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. The work to develop the Global Code commenced in May last year, when the BIS Governors commissioned a working group of the Markets Committee of the BIS to facilitate the establishment of a single global code of conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the code.2 There are two important points worth highlighting: first, it’s a single code for the whole industry and second, it’s a global code. On the first point, the Global Code is replacing the existing codes of conduct that have been present in the FX market, including the NIPS code here in London. On the second point, the Code covers all of the wholesale FX industry. This is not a code of conduct for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; its breadth is both across the globe and across the whole structure of the industry. The Code is intended to apply to all aspects of the wholesale foreign exchange market. I am chairing this work, with Simon Potter of the Federal Reserve Bank of New York leading the work on developing the code and Chris Salmon of the Bank of England leading the adherence work. Our Working Group comprises representatives of the central banks of all the major FX centres, drawing on the membership of the Markets Committee which is comprised of heads of 1/4 BIS Central Banker's Speeches the market operations areas of the 15 major currency areas.3 Given our roles, we are all very much interested in the effective functioning of the FX market. Again, it is very much a global effort reflecting the global nature of the foreign exchange market. This work is also very much a public sector–private sector partnership. In that regard, we are being ably and vigorously supported in this work by a group of market participants, chaired by David Puth, CEO of CLS. The group contains people from all around the world on the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants, drawing from the various Foreign Exchange Committees (FXCs) and beyond. There are a number of members of David’s group that are from the London market including non-banks, platforms, asset managers as well as banks. Hence all parts of the market are being involved in the drafting of the code to make sure all perspectives are heard and appropriately reflected. At the outset we decided to split the topics we intend to cover in the Code into two parts. This first phase covers areas such as ethics, information sharing, aspects of execution and confirmation and settlement. The second phase is covering further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. We have made substantial progress in drafting the second phase. It will be circulated for comment through the various FXCs in early October. So, the JSC will be providing feedback on behalf of the London market. As was the case with the first phase, there will be three opportunities for market participants to provide feedback on the material over the next six months or so. We will endeavour to make clear how the feedback provided has been addressed through each of the feedback phases. The aim is for the full Code to be published in May 2017 and we are on track to achieve that. I will now talk about a couple of the areas that are addressed in the first phase of the Code, which is already in the public domain. In the first phase, topics were covered that the market was looking for guidance on sooner rather than later and that were potentially having an adverse effect on market functioning. One example of this is around information sharing, where many market participants have highlighted that they are unsure what information can be conveyed to counterparties and other market participants. While it is clear (or at least should be) that disclosing the details of a client’s order book to a counterparty is not acceptable, market participants have noted that there is much less clarity around what level of aggregation, say, is necessary in order to convey market colour appropriately. As a result, it appears some market participants are being very conservative in sharing information, which can have implications for the effective functioning of the market. This is notwithstanding the guidance provided in this area in the Global Preamble put out by the global Foreign Exchange Committees, in March 2015.4 The Global Code takes the material in the Global Preamble and fleshes it out a bit more, including with some examples of what is, and isn’t, appropriate communication, and why. There will be more examples on information sharing provided in the second phase of the Code. Similarly, there have been diverse opinions around what is appropriate behaviour in terms of order handling. While there have been some very public instances of inappropriate behaviour around order handling that have come to light in recent years, in other areas, the market is seeking greater guidance as to what principles should be followed, including the different standards that may apply depending on whether an intermediary is functioning as principal or agent.5 This is one area that was not adequately covered in the pre-existing codes of conduct that the 2/4 BIS Central Banker's Speeches various FXCs had endorsed for the FX market. It is an area where we are aiming to provide the sought-after guidance. But we are not writing a procedures manual for order handling. Rather we are articulating principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manual. Our aim in articulating these principles is to provide market participants with the framework in which to think about how they handle stop-loss orders. The emphasis here is very much on the word ‘think’. The Global Code will not provide the answers to all your questions, but it should help you ask the right questions. In a similar vein, I will repeat a point that I have made a number of times in the past. One of our most central aims in drafting the Code is for it to be principles-based rather than rules-based. There are a number of reasons why this is so, but for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. If it’s not expressly prohibited or explicitly discouraged, then it must be okay seems to be the historical experience. Moreover, the more prescriptive and the more precise the code is, the less people will think about what they are doing. If it’s principles-based and less prescriptive then, as I just said, market participants will have to think about whether their actions are consistent with the principles of the Code. Adherence to the Code Alongside drafting the Code, we have also been devoting considerable time and effort to thinking about how to ensure widespread adoption of the Global Code by market participants. Clearly, that has been an issue with the various existing codes that have been in place in a number of markets over many years. It is evident that they were ignored on occasion, wilfully or otherwise. As I said earlier, we are working with the industry to produce a principles-based code of conduct rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. But we do expect the principles in the Code to be understood and adopted across the entire FX market. We laid out our overall approach to adherence to the Code in New York in May. 6 Chris Salmon will speak further on adherence in the coming weeks. Simon Potter spoke recently in New York about the philosophy underpinning our work.7 We intend to work closely with market participants in the period ahead to facilitate the development of market-based mechanisms which demonstrably embed the Global Code within firms’ culture and practices. These mechanisms need to be sensitive to existing law and regulation and to the diverse nature of FX markets globally. Hence a ‘one size fits all’ approach to adherence would not be appropriate. We need to strike the right balance between respecting the existing diversity across different markets, and establishing globally consistent and effective adherence mechanisms. The adherence to a voluntary code will only come about if firms judge it to be in their interest and take the practical steps to ensure the code is embedded in their practices. Firms will need to take practical steps such as training their staff and putting in appropriate policies and procedures. We will probably recommend widespread use of attestations by firms about their adherence to demonstrate how widely the Code is followed. Firms are more likely to adhere to the Code if they believe that their peers are doing so too. The success of the Global Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. That is why the Global FXCs issued a joint statement of support at the launch of the Code in New York, making clear their intention for the Global Code to become an integral part of the wholesale FX market.8 Furthermore the BIS central banks signalled their commitment by announcing that they 3/4 BIS Central Banker's Speeches themselves will follow the Code, and that they expect that their counterparties will do so too.9 We are also talking to regulators in our various countries as to how they might use the Code in monitoring market conduct. We are on track to complete the Code so that it will be released following the Global Foreign Exchange Committee meeting here in London in May 2017. At the end of that process, for the code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed by the FXCs and market participants more generally. That said, the process does not really end, because as the foreign exchange market continues to evolve, the Code will need to evolve with it. Conclusion That, I trust, gives you a reasonable overview of the state of play on the Global Code. A lot of work has been done to get us to this point. There is still work to be done to complete the task. The work to date has reflected a very constructive and cooperative effort between the central banks and market participants. All of us recognise the need to restore the public’s faith in the foreign exchange market and the value of the Global Code in assisting that process and also in helping improve market functioning and confidence in how the market functions. I expect that cooperative relationship will continue as we see this process through to its conclusion in May next year. 1 See <www.bis.org/mktc/fxwg/gc_may16.pdf>. 2 See <www.bis.org/press/p150511.htm>. 3 See <www.bis.org/about/factmktc/fxwg.htm>. 4 See <www.rba.gov.au/afxc/about-us/pdf/global-preamble.pdf>. 5 I am not using these terms in the legal sense that is sometimes the case in particular jurisdictions, but rather in terms of common market parlance. 6 See <www.bis.org/mktc/fxwg/am_may16.pdf>. 7 S Potter, ‘The Role of Best Practices in Supporting Market Integrity and Effectiveness’, Remarks at the 2016 Primary Dealers Meeting, Federal Reserve Bank of New York, New York City, 7 September 2016. 8 <afxc.rba.gov.au/news/afxc-26052016.html> 9 <www.bis.org/press/p160526a.htm> 4/4 BIS Central Banker's Speeches | reserve bank of australia | 2,016 | 9 |
Opening statement by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 22 September 2016. | Philip Lowe: Monetary policy framework, recent economic developments and Reserve Bank of Australia’s major projects Opening statement by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 22 September 2016. * * * Chair and members of the Committee These hearings have become a significant part of our calendar. They are an important way through which the Reserve Bank is accountable to the public. I, myself, have been attending these hearings for more than a decade in various roles. I look forward now, in my new capacity as Governor, to continuing the tradition of productive engagement between the Committee and the Reserve Bank. You can be assured that I will do my best to answer your questions constructively and I look forward to regular hearings over coming years. In my opening remarks, I would like to cover three sets of issues. The first is the monetary policy framework. The second is recent economic developments in Australia and elsewhere. And the third is the major projects that the Reserve Bank is currently undertaking. The Monetary Policy Framework Earlier this week, the Treasurer and I released an updated Statement on the Conduct of Monetary Policy. These statements – the first of which was released in 1996 – record the common understanding between the Reserve Bank and the Government on key aspects of Australia’s monetary and central banking policy framework. They also set out agreed arrangements that promote the transparency and accountability of the Bank. Over recent times, there has been quite a lot of public commentary in Australia and elsewhere about monetary policy frameworks. As you would expect, we are always studying the various arguments and have followed the recent debate carefully. Our view is that a flexible medium-term inflation target remains the right monetary policy framework for Australia. This was reaffirmed in the new Statement on the Conduct of Monetary Policy, which has also been endorsed by the Reserve Bank Board. The goal remains for CPI inflation to average between 2 and 3 per cent over time. The current framework was introduced in the early 1990s and has served Australia well. It provides the community with a reasonable degree of certainty about how the average level of prices is likely to change over the medium term. This helps people when making decisions about their savings and investments. Low and stable inflation remains an important precondition for strong and sustainable growth in employment and incomes. It is worth emphasising that ever since the adoption of the current framework, the Reserve Bank has been a proponent of what is known as flexible inflation targeting. We have not seen our job as always keeping inflation tightly in a narrow range. We have not been what some have called ‘inflation nutters’. We have had a more balanced perspective, recognising that some degree of variability in inflation from year to year is both inevitable and appropriate. In particular, a flexible medium-term target is the best way for us to deliver low and stable inflation in a way that contributes to our other broad responsibilities, including employment and preserving financial stability. We want to ensure that we deliver an average rate of inflation in Australia of between 2 and 3 per cent over time. It is in the public interest that we do this. It is also in the public interest that we pursue this objective in a way that promotes good employment outcomes for the country and preserves financial stability. In this way, we can best contribute to the 1/5 BIS Central Banker's Speeches economic prosperity and welfare of the Australian people as required by the Reserve Bank Act. Our judgement, then, is that a flexible medium-term inflation target remains the right monetary policy framework for Australia. While there are arguments for other types of arrangements, none of them is sufficiently strong to move away from the current framework, which has helped promote stability and confidence in the Australian economy. So the new Statement on the Conduct of Monetary Policy represents continuity with the previousStatement. The main drafting change is to make the link between monetary policy and financial stability a little more direct. In the previous Statement, monetary policy and financial stability were dealt with in separate parts of the document. Yet, over the years, financial stability considerations have been a factor in our monetary policy deliberations. Recently, for example, we have considered that a very quick return of inflation to the 2 to 3 per cent range at the cost of a material deterioration in the health of private sector balance sheets was unlikely to be in the public interest. The revised drafting recognises that our inflation target is pursued in the context of the Bank’s broader objectives, including financial stability. Recent Economic Developments I would now like to turn to the recent economic data. Our economy continues its transition following the boom in commodity prices and mining investment. According to the latest national account, GDP increased by 3.3 per cent over the year to June. This was a better outcome than was widely expected a year ago. It is also a little above most estimates of trend growth in our economy. Partly reflecting this above-trend growth, the unemployment rate has declined by around ½ percentage point over the past year. Again, this is a better outcome than was thought likely a year ago. As is always the case, these aggregate outcomes mask significant variation across industries and regions. Those parts of the economy that benefited most from the resources boom are now experiencing difficult conditions, while other areas are doing considerably better. In these other areas, business conditions have improved, employment has increased and there are some signs of a modest pick-up in private investment. Overall, the economy is adjusting reasonably well to the unwinding of the biggest mining investment boom in more than a century. This is a significant achievement. We are managing this adjustment partly because of the flexibility of the exchange rate and the flexibility of wages and through the support provided by monetary policy. The story on income growth has been less positive, with growth in nominal GDP being disappointing. Over the past five years, nominal GDP has increased at an average rate of around 3 per cent per year. To put this number in context, between 2000 and 2007, nominal GDP grew at an average rate of 7½ per cent per year. This is quite a change. It goes some way to explaining the sense of disappointment in parts of the community about recent economic outcomes. The main reason for the weak income growth over recent times is the large fall in the prices received for our exports. Since the September quarter 2011, export prices have fallen by around one-third. This fall, though, does need to be kept in perspective. Export prices remain considerably higher than they were in the 1990s and early 2000s, relative to the price of our imports. And of course, some of the fall in prices is because of increased production from Australia. So while we are receiving lower prices for our exports, we are selling more. The recent news on commodity prices has been a bit more positive than it has been for a while. Over the past couple of months, the prices of some of our key exports have risen, partly in response to production cutbacks by high-cost producers elsewhere in the world. While it is 2/5 BIS Central Banker's Speeches difficult to predict the future, if these increases were to be sustained then we could look forward to the drag on national income from falling commodity prices coming to an end. A second factor that has weighed on growth in nominal GDP is the slow rate of wage increases. This is a common experience across most industrialised countries at present, even those with strong employment growth. In Australia, the current rate of wage growth is the slowest in around two decades. It is part of the adjustment following the resources boom. Importantly, it means that many more people have jobs than would otherwise have been the case. The low wage growth and lower commodity prices have meant that CPI inflation has been quite low over recent times. Inflation has also been held down by increased competition in parts of retailing and cost reductions in some supply chains. Slow growth in rents has also played a role. The low inflation outcomes have provided scope for monetary policy to provide additional support to demand. The Reserve Bank Board decided to reduce the cash rate by 25 basis points in May and again in August this year. Lending rates have come down as a result. Deposit rates have, of course, also come down. The Board is very conscious that this means lower interest income for savers. Overall though, our judgement is that this easing in monetary policy is supporting jobs and economic activity in Australia, and thus improving the prospects for sustainable growth and inflation outcomes consistent with the medium-term target. Looking forward, we expect the economy to continue to be supported by low interest rates and the depreciation of the exchange rate since early 2013. Importantly, the drag from the fall in mining investment will also come to an end. While mining investment still has some way to fall, our estimate is that around three-quarters of the total decline is now behind us. Inflation is expected to remain low for some time, but then to gradually pick up as labour market conditions strengthen further. One issue that has attracted a lot of attention of late is the housing market. The construction cycle has a bit more momentum than we expected earlier. This is adding to the supply of housing in the country, which partly explains the slow growth in rents. The rate at which established housing prices are increasing has also moderated, although there remain some pockets where prices are increasing briskly. Credit growth and turnover in the housing market are also lower than they were a year ago. Under APRA’s guidance, lending standards have also been tightened. Overall, then, the situation is somewhat more comfortable than it was a year ago, although we continue to watch things carefully. If I could now turn to the international environment. The overall picture is as it has been for some time. The global economy is continuing to expand, but at a rate a little below average. Growth in global trade and investment is subdued. Inflation is also generally low and below most central bank targets. And interest rates in many countries are still very low. One issue that continues to attract a lot of attention is the global monetary environment. As we have talked about on previous occasions, at the global level there has been a very heavy reliance on monetary policy to stimulate growth. Some central banks have taken extraordinary actions, including large-scale money creation and setting negative policy interest rates. This has had global ramifications. While these actions have generally not been taken with the direct intention of influencing exchange rates, they have, inevitably, affected international capital flows and exchange rates. We have seen the effects here in Australia. The monetary expansion elsewhere and the low rates on offer overseas have meant that foreign investors have found Australian assets, with their relatively higher returns, attractive. In this way, what is happening elsewhere affects us here in Australia. 3/5 BIS Central Banker's Speeches In the past 24 hours, there have been much-anticipated policy meetings by the Bank of Japan and by the Federal Reserve in the United States. These meetings followed a reassessment in markets about the potential for further stimulus from some major central banks, which saw bond yields rise from their historically low levels. In the event, the Bank of Japan and the Federal Reserve did not make material changes to their policy stances. In both cases, policy remains highly accommodative. The Federal Reserve’s statement did note, though, that the case for an increase in the federal funds rate had strengthened. Another area that continues to be watched closely is the unfolding transition in the economy of our largest trading partner, China. As we have discussed previously, growth in China has slowed as China too makes a difficult economic transition: in its case, from growth being driven by large investments in industrial capacity and property to a more consumption-focused and service-based economy. China is also dealing with the consequences of a large build-up of debt in the private and state-owned business sectors. Overall, the latest available data suggest that there has not been a major interruption to growth, although this is partly because the economy is being supported by fiscal policy, including expenditure on infrastructure. So the Chinese authorities face a difficult trade-off: measures to address industrial overcapacity and high debt levels are necessary over the longer term, but are not helpful in the short term. We all have a strong interest in them managing this trade-off smoothly. RBA Projects Finally, I would like to say a few words about three of the major public-interest projects that the Bank has been working on recently. You will – I hope – have noticed that a new $5 banknote was issued on 1 September. We are very proud of it. It has innovative security features, including the world’s first clear top-to-bottom window. If you have had one in your hands you will have also noticed a tactile feature to assist the vision impaired. We anticipate releasing a new $10 banknote next year and then the banknote in highest circulation – the $50 – after that. The rationale for introducing new banknotes is that we want to make sure that counterfeiting rates in Australia remain low. Our current banknotes have stood the test of time, but as technology has improved so have counterfeiting capabilities, and there has been some increase in counterfeiting. Our investment in new, high-tech banknotes will help ensure that Australians can continue to have confidence in our banknotes. As part of this project, we are also building a new large vault and a technologically sophisticated, more efficient cash processing facility in Craigieburn in Victoria, as our existing arrangements are running up against capacity constraints. A second major project is the New Payments Platform. This project has been under the guidance of the Reserve Bank’s Payments System Board. It is a cooperative effort between the Bank and the payments industry to modernise key parts of our electronic payments system. When this work is completed we will all be able to make instantaneous payments to one another, with the money transferring between accounts in a matter of seconds, even if the funds have to move between banks. Addressing will be simplified; an email address or a mobile phone number will be able to be used instead of a payer needing to know an account number and BSB. We will also be able to send a lot more information with payments. The first payments using this new system should be able to be made late next year. As one part of our contribution to this project, the Reserve Bank is building the necessary infrastructure to allow funds to be transferred between financial institutions in real time. A third major project is the renovation of our banking infrastructure. The Reserve Bank is the main transactional banker for the Australian Government. Like other financial institutions, we 4/5 BIS Central Banker's Speeches need to keep investing in technology so that we can provide a high level of service to our customers. As part of this work, we are developing systems so that the government can use the New Payments Platform to make, and receive, some of its payments. So it is a busy time at the Reserve Bank. Further details on these and other projects that we are working on will be available in the Bank’s annual report, which will be tabled in parliament and released mid next month. Thank you. My colleagues and I are here to answer your questions. 5/5 BIS Central Banker's Speeches | reserve bank of australia | 2,016 | 9 |
Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to Citi's 8th Annual Australian and New Zealand Investment Conference, Sydney, 18 October 2016. | Philip Lowe: Inflation and monetary policy Address by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to Citi's 8th Annual Australian and New Zealand Investment Conference, Sydney, 18 October 2016. * * * I would like to thank James Bishop, Andrea Brischetto and Merylin Coombs for assistance in the preparation of this talk. I would like to thank Citi for the invitation to speak at this year’s Investment Conference. I am very pleased to be here. This is my first speech as Governor of the Reserve Bank of Australia, so I would like to organise my remarks around the topic of inflation and monetary policy. Nominal interest rates around the world have been at record low levels for some years and there has been extraordinary balance sheet expansion by a number of the world’s major central banks. Yet, at the same time, inflation rates in most advanced economies remain below target. There are also concerns in some economies that inflation expectations have declined too far and are perhaps stuck at levels that are too low. This is quite a different world to the one that has existed over the past half-century. Indeed, I am the first Governor of the RBA to have taken office where the concern of the day is more that inflation might turn out to be a bit too low rather than a bit too high. This morning I would like to focus on three interrelated issues. The first is why we have seen these low inflation outcomes across much of the world. The second is how we think about the low inflation outcomes in Australia in the context of our flexible medium-term inflation target. And the third is decisions on monetary policy by the Reserve Bank Board over recent times. Low Global Inflation: Why? It is always useful to start with the facts. This first graph (Graph 1) shows the average rate of inflation for a range of countries over the past two years (the blue bars) as well as the average rate over the past 20 years (the black dots). In almost all economies, inflation has recently been noticeably below its long-term average. 1 / 13 BIS central bankers' speeches This second graph (Graph 2) shows a time series of headline and core inflation rates averaged across the major advanced economies. Again, the picture is clear. While headline inflation has picked up a little recently, the outcomes over recent years have been the lowest for many decades, with the exception of a short period during the global financial crisis. Core inflation rates have also been low, although not as remarkably so, as they do not capture the large fall in oil prices over recent years. 2 / 13 BIS central bankers' speeches This third graph (Graph 3) shows inflation rates for Australia. The two measures shown are headline CPI inflation and the trimmed mean measure. We too have now joined the club of countries with headline inflation noticeably below the medium-term average, although we are a more recent member than many others. Headline inflation here is 1 per cent and measures of underlying inflation are running at around 1½ per cent. 3 / 13 BIS central bankers' speeches These low inflation outcomes globally and in Australia are coexisting with low wage outcomes. In many industrialised countries, wage growth has been close to multi-decade lows and below what historical relationships with the unemployment rate would suggest. So why has this been happening? There are three main factors at work. The first – and the most conventional – explanation is that the low inflation reflects the economic slack in the global economy. Economic growth has generally disappointed since the global financial crisis, weighed down by an overhang of debt. The result is that excess capacity exists in many parts of the global economy. Broad measures of labour utilisation continue to suggest ongoing slack, despite unemployment rates in some industrialised economies being the lowest in some decades. And in parts of Asia, there is considerable overcapacity in some manufacturing industries. This collective economic slack has reduced upward pressure on both prices and wages. The second factor is a self-reinforcing dynamic originating from the decline in headline inflation caused by the fall in commodity prices, including oil prices. With headline inflation rates so low, many workers have agreed to smaller wage increases than would have otherwise been the case, especially where expectations of future inflation are also low. The low wage increases have in turn reinforced the low inflation outcomes. 4 / 13 BIS central bankers' speeches The third factor is that there has been a shift in the perceived pricing power of many workers and businesses. This could simply be the consequence of the increased economic slack but, in my view, there is something more structural going on, driven by the globalisation of markets and technology. Perhaps the strongest effect of globalisation is that it increases competition. This is one reason why open markets can be such a positive force for our collective good. But, in many cases, increased competition means less pricing power, which means a lower level of prices. Open markets and advances in technology mean that more businesses feel that if they put their prices up, they will not only lose market share to domestic competitors but to foreign competitors as well. Many workers have a similar feeling. For some decades, workers in the manufacturing sectors in most industrialised economies have felt the pressure of competition from international trade. Today, many workers in the services sectors are now also feeling this same pressure, as they too are exposed to the increased competitive pressure from globalisation and technology. And faced with more potential competitors, workers, like firms, are less inclined to put their prices up. Another contributing factor is that many workers and companies still carry scars from the financial crisis. The crisis generated a lot of uncertainty and increased the value placed on job security. This occurred just at the time that other structural changes in the economy were making jobs less secure. This increased value put on job security has made many workers less inclined to push for large wage rises. So the low inflation outcomes in the advanced economies reflect a combination of three factors – excess capacity, lower commodity prices and perceptions of reduced pricing power. I would like to offer some reflections on these three factors from an Australian perspective. First, excess capacity. While the Australian economy has performed better than many others over the past decade, we still have some spare capacity. Determining exactly how much is difficult, but Bank staff estimate that the current unemployment rate of 5.6 per cent is around ½ percentage point or a bit more above full employment. While this gap has narrowed over the past year, we do still have some spare capacity. Looking at broader measures of labour market utilisation reinforces this point (Graph 4). Over the past year, the Australian Bureau of Statistics’ (ABS) measure of underemployment has risen, not fallen, so that overall labour market underutilisation has been little changed. This largely reflects the fact that many of the people finding work recently have been employed in part-time jobs and report that they would like to work more hours. 5 / 13 BIS central bankers' speeches The second factor is the decline in commodity prices. The most direct effect is the fall in petrol prices. Over the past two years, the price of petrol in Australia has declined by around 20 per cent. This has lowered the year-ended rate of headline inflation by almost 0.4 percentage points over each of these years. More broadly though, the decline in commodity prices has perhaps had a bigger effect in Australia than elsewhere, given that it has weighed on our aggregate income and thus demand. Over the past five years, the prices of Australia’s commodity exports have fallen by more than 50 per cent and Australia’s terms of trade have fallen by 35 per cent as a result, which is the main reason that growth in national income has been weak over recent years. The third factor is the feeling of reduced pricing power, partly from greater competition. One good example of this is in the retail sector, where the entry of foreign retailers has made a real difference in groceries and clothing. Over recent times, food price inflation has been unusually low and the prices of many goods have not risen as quickly as suggested by the conventional relationship with import prices.1 Increased competition has forced existing retailers to find efficiencies to lower their cost bases and, in turn, their prices. Reflecting this, there has been a pick-up in the rate of productivity growth in the retail sector, which is good news for consumers. More broadly, though, many Australian workers are facing some of the insecurities that workers in other advanced economies are facing. The effects of these three factors – excess capacity, lower commodity prices and reduced pricing power – are evident in the wage outcomes in Australia. In particular, the wage price index 6 / 13 BIS central bankers' speeches (WPI) has increased by just over 2 per cent over the past year, which is the slowest rate of increase since the series began in the late 1990s (Graph 5). The Reserve Bank and the ABS have been working together to obtain some additional insight into what is happening here. Together we have looked at the wage increases for all the 18,000 individual jobs that the ABS uses to construct the WPI. The results are interesting. Over recent years, there has been a decline in the frequency of wage increases and, when wage increases do occur, the average size is lower (Graph 6). The decline in the average size of increases is largely due to a very sharp drop in the share of jobs where wages are increasing at what, by today’s standards, would be considered a rapid rate. For example, six years ago, almost 40 per cent of the 18,000 individual jobs being tracked by the ABS received a wage increase in excess of 4 per cent (Graph 7). In contrast, over the past year, less than 10 per cent of jobs got this type of wage increase. And almost half of the individual jobs tracked by the ABS had a wage increase of between 2 and 3 per cent. 7 / 13 BIS central bankers' speeches 8 / 13 BIS central bankers' speeches The low CPI and wage outcomes in Australia have seen some decline in inflation expectations, although not to the levels seen in many other countries. Consumer inflation expectations are lower than they were some years back, but are not at unprecedented levels (Graph 8). Marketbased measures of long-term inflation expectations have also declined, but they remain consistent with the inflation target. 9 / 13 BIS central bankers' speeches Looking to the future, we expect that the various factors holding inflation down will continue for a while yet. But this does not mean that we have drifted into a world of permanently lower inflation in Australia. Domestic demand is expected to strengthen gradually as the drag on our economy from the decline in mining investment comes to an end. As this happens, the excess capacity, including in the labour market, is likely to be wound back. Some pick-up in wages and prices could then be expected. In addition, commodity prices, after having declined over the preceding four years, have increased this year. If sustained, this will boost national income and falls in petrol prices will no longer be having a significant effect on headline inflation. In terms of the downward pressure on prices and wages from increased competition, this is likely to continue for a while yet, but it is probable that this pressure will lessen at some point as domestic demand strengthens. Putting all this together, our central forecast remains that inflation in Australia will gradually pick up over the next couple of years, although it is still likely to be closer to 2 per cent than 3 per cent by the end of this period. Flexible Inflation Targeting I would now like to turn to the monetary policy framework as this provides the structure within which the Reserve Bank Board makes its decisions. The centrepiece of this framework is a 10 / 13 BIS central bankers' speeches flexible medium-term inflation target, with the objective of delivering an average rate of inflation over time of between 2 and 3 per cent. By achieving this we can provide a strong medium-term anchor for people’s inflation expectations and reduce one element of uncertainty in the economy. This is an important precondition to sustainable growth in employment and incomes. Most people can cope without too much difficulty with a bit of variation in inflation from year to year, but it is the medium-term uncertainty that is really damaging to planning. I hope that it is well understood that our framework allows for temporary deviations of inflation from the medium-term target. In this regard, we have a degree of flexibility not available to some other central banks that have a singular focus on inflation. Some of these central banks have felt that given their mandates they had little choice but to take whatever measures were available to them to push inflation higher. We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 per cent at all times. Indeed, since June 1993, CPI inflation has been below 2 per cent for 24 per cent of the time, and coincidentally above 3 per cent for 23 per cent of the time. What is important is that we deliver an average rate of inflation consistent with the medium-term target. Given the flexibility in our arrangements, it is a perfectly reasonable question to ask what degree of variation in inflation is acceptable. I can’t give you a precise quantitative answer here. What I can do, though, is explain how we think about this issue. The general starting point is to ask: what is in the public interest? The medium-term inflation target is pursued as way of achieving our broad goals as set out in legislation. This legislation, which was passed in 1959, states that the Reserve Bank Board must exercise its powers in a way that best contributes to: (i) the stability of the currency of Australia; (ii) the maintenance of full employment in Australia; and (iii) the economic prosperity and welfare of the people of Australia. 2 These are lofty goals and, in my new position, I feel the weight of them. So when thinking about what type of variation in inflation is acceptable, it is natural for us to start by asking ourselves: what is in the public interest? Granted, this can be hard to define and opinions can differ. But, when thinking about the issue, there are two factors that have particular prominence. These are employment and the stability of the financial system. When we find ourselves with inflation that is either lower, or higher, than normal, we want to feel confident that, over time, inflation will return to more normal levels. There is, however, always a choice about the exact path we take. When thinking about that choice, developments in the labour market and in balance sheets in the economy have particular importance. Take the current situation of low inflation as an example. Over recent times, we have considered the impact of our decisions not only on the future path of inflation, but also on the health of the balance sheets in the economy. Achieving the quickest return of inflation back to 2½ per cent would be unlikely to be in the public interest if it came at the cost of a weakening of balance sheets and an unsustainable build-up of leverage in response to historically low interest rates. Conversely, the case for moving more quickly would be strengthened in a world where the labour market was deteriorating and people were having increasing difficulty finding jobs. To be clear, our core objective is to deliver a rate of inflation that averages between 2 and 3 per cent over time. But we want to do that in a way that best serves the public interest. A flexible medium-term inflation target, paying close attention to the labour market and keeping a wary eye 11 / 13 BIS central bankers' speeches on balance sheets in the economy is the best way of doing this. This framework has served Australia well for more than two decades now. And, in my view, it remains the right monetary policy framework for Australia. This might all be less tightly defined than some people would like. But given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable. Inevitably, judgement has to be exercised. Successive governments have appointed nine dedicated Australians to the Reserve Bank Board to exercise that judgement in the public interest. I recognise that not everybody agrees with the decisions that the Board makes. The best way of dealing with this is for us to communicate as clearly as possible the reasons for the decisions that we have made. I am committed to doing that to the best of my ability. So this is an appropriate point to talk about the Reserve Bank Board’s decisions over recent times. Recent Decisions Over the course of this year the Board has lowered the cash rate twice, in May and August. These reductions followed inflation outcomes early in the year that were lower than expected as well as an assessment that inflation was likely to remain quite low for some time, for the reasons that I have discussed. The easing in policy was not in response to concerns about economic growth. If anything, the growth outcomes over the past year, as measured by real GDP or the trend in unemployment, have been a bit better than expected. In easing policy, the Board has been conscious that interest rates are already low – very low in fact, by historical standards. These low rates are, in part, a consequence of what has been happening abroad. Monetary settings elsewhere in the world have affected international capital flows and exchange rates, and interest rates here in Australia too. The Board has also been conscious that the low rates mean low returns for many savers. In addition, the Board has paid close attention to developments in household balance sheets and the housing market. Over the course of 2016, there has been some lessening of the concerns that were building up last year. Aggregate credit growth slowed, as did the rate of housing price appreciation. Lending standards were also tightened. These developments meant that the Board felt that the lowering of the cash rate would improve prospects for sustainable growth and achieving the inflation target without creating unacceptable risks on the financial side. Over the past couple of months, the Board has held the cash rate steady at 1.5 per cent. We have continued to carefully examine the incoming flow of data. On balance these data suggest that the economy is continuing to adjust reasonably well to the downswing in mining investment. This downswing still has some way to go, but the end is now in sight. And recently, commodity prices have picked up, which is a marked change from the large declines in prices we have seen for some years. Measures of business and consumer sentiment are also slightly above average. In terms of inflation, we have been looking carefully at the various measures of inflation expectations, which have clearly declined, although not to unprecedented levels. The experience elsewhere suggests that we do need to guard against inflation expectations falling too far, for if this were to occur it would be more difficult to achieve the inflation target. Of course, one of the key influences on inflation expectations is the actual outcomes for inflation. We will get an important update next week, with the release of the September quarter CPI. In terms of the labour market, as I said earlier, the picture is mixed. The unemployment rate has 12 / 13 BIS central bankers' speeches drifted down, but growth in hours worked is weak and many part-time workers would like to work longer hours. Wage pressures remain weak, although there are some signs that the downward pressure on average wages from workers moving out of high-paying mining-related jobs might be coming to an end. The recent data on the housing market are also mixed. Prices seem to be increasing quite briskly again in some areas, although are falling in others. Growth in rents is very low and there is a big increase in housing supply still to come. To add to the picture, credit growth is still exceeding income growth, although by a smaller margin than last year. It is also noteworthy that much of this credit is being used to finance new housing construction rather than consumption. It is a complex picture. So these are the issues we have been focused on. At its most recent meeting, the Board reached the judgement that holding the cash rate at 1.5 per cent was consistent with sustainable growth in the economy and achieving the inflation target over time. We will, of course, continue to review that judgement at future meetings. Conclusion We continue to live in unusual times. Inflation is quite low and growth in labour costs has been very subdued. While this largely reflects the usual cyclical factors, to some extent there is more than that going on. The low inflation outcomes around the world have posed some challenges for policy frameworks, including inflation targeting. But our flexible medium-term target has served us well. The Reserve Bank can contribute to stability and confidence in the Australian economy by continuing to be guided by this framework, which has proved its worth for over two decades now, and to use the flexibility afforded by the framework to respond sensibly to the situation we face. Of course, we have to explain that response and I hope these remarks today have assisted in that regard. I remain confident that the framework we have, sensibly operated, will guide us to prudent decisions in pursuit of what is, after all, the ultimate goal of our policy: the welfare and prosperity of the people of Australia. Thank you. 1 See Ballantyne A and S Langcake (2016), ‘Why has Retail Inflation been so Low?’, RBA Bulletin, June, pp 9-17. 2 See Section 10(2) of the Reserve Bank Act 1959 (<www.legislation.gov.au/Details/C2015C00201>) 13 / 13 BIS central bankers' speeches | reserve bank of australia | 2,016 | 10 |
Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to FINSIA's Regulators Panel, Melbourne, 11 November 2016. | Guy Debelle: The Global Code of Conduct for the Foreign Exchange Market Remarks by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to FINSIA's Regulators Panel, Melbourne, 11 November 2016. * * * Today I am going to talk about the Global Code of Conduct for the Foreign Exchange Market, which has been consuming a large part of my sleeping hours for the past 18 months. As I hope most of you know, Phase 1 of the Code was launched earlier this year in New York. 1 The complete Code will be released in London at the end of May 2017. It is pretty easy to find. It is available on the Australian Foreign Exchange Committee (AFXC) website or via the Bank for International Settlements (BIS) website. Today I will reiterate the motivation for the work we are doing on the Code, why you all should be interested in it, and then update you on where we are at with the process and outline the way forward. Why is the work going on? As I have stated before, the foreign exchange (FX) industry has been suffering from a lack of trust in its functioning. This lack of trust is evident both between participants in the market, and at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. A well-functioning foreign exchange market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Code sets out global principles of good practice in the foreign exchange market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to restore confidence and promote the effective functioning of the wholesale FX market. The work to develop the Code commenced in May last year, when the BIS Governors commissioned a working group of the Markets Committee of the BIS (which I Chair) to facilitate the establishment of a single global code of conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the code.2 Our Working Group comprises representatives of the central banks of all the major FX centres. This work is also very much a public sector–private sector partnership. We are being ably and vigorously supported in this work by a group of market participants, chaired by David Puth, CEO of CLS. The group contains people from all around the world on the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and nonbank participants, drawing from the various Foreign Exchange Committees (FXCs) and beyond. Hugh Killen from Westpac is the Australian member of this group, representing the Australian Foreign Exchange Committee (AFXC). All parts of the market are being involved in the drafting of the code to make sure all perspectives are heard and appropriately reflected. There are two important points worth highlighting: first, it’s a single code for the whole industry and second, it’s a global code. On the first point, the Code is replacing the existing codes of conduct that have been present in the FX market, including the ACI model code used here in Australia. Importantly, the Code covers 1/3 BIS central bankers' speeches all of the wholesale FX industry. This is not a code of conduct for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; its breadth is both across the globe and across the whole structure of the industry. Hence the Code is relevant for all of you here in this room. The way it is relevant will depend on your engagement with the market. The guidelines for appropriate conduct are relevant for the buy side as well as the sell side. On the buy side it will also help to give you guidance as to what you can reasonably expect from your counterparty as you transact your FX business. As I mentioned earlier, the first phase of the Code was released earlier this year. It covers areas such as ethics, information sharing, aspects of execution and confirmation and settlement. We are well advanced with the second phase which is covering further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. We are currently in the process of incorporating nearly 2000 comments received from market participants on the draft that we circulated in early October. We will be sending out a revised version for comment in the first week of December. The distribution to market participants will be principally through the FXCs but also through other industry associations as well. Again, we are endeavouring to ensure all perspectives are appropriately reflected in the Code. The aim is for the full Code to be published in May 2017 and we are on track to achieve that. Adherence to the Code Alongside drafting the Code, we have also been devoting considerable time and effort to thinking about how to ensure widespread adoption of the Code by market participants. Clearly, that has been an issue with the various existing codes that have been in place in a number of markets over many years. It is evident that they were ignored on occasion, wilfully or otherwise. One of our central aims in drafting the Code is for it to be principles-based rather than rulesbased. There are a number of reasons why this is so, but for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. If it’s not expressly prohibited or explicitly discouraged, then it must be okay seems to be the historical experience. Moreover, the more prescriptive and the more precise the code is, the less people will think about what they are doing. If it’s principles-based and less prescriptive then, as I just said, market participants will have to think about whether their actions are consistent with the principles of the Code. So, we are working with the industry to produce a principles-based code of conduct rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. But we do expect the principles in the Code to be understood and adopted across the entire FX market. Our approach to adherence has a number of dimensions. We laid out our overall approach to adherence to the Code in New York in May.3 One dimension is market-based adherence mechanisms. An important element of discipline should come from the market itself and we are working closely with market participants on this. The adherence to a voluntary code will only come about if firms judge it to be in their interest and take the practical steps to ensure the code is embedded in their practices. Firms will need to take practical steps such as training their staff and putting in appropriate policies and procedures. We will probably recommend widespread use of attestations by firms about their adherence to demonstrate how widely the Code is followed. Firms are more likely to adhere to the Code if they believe that their peers are doing so too. 2/3 BIS central bankers' speeches Without blaming them for what occurred, more scrutiny from counterparties about how their FX transactions were being executed may have helped to reduce the incidence and severity of the market abuses that occurred in the past. FX transactions were sometimes regarded as ancillary to the core business, notwithstanding their potential impact on returns. Ultimately the success of the Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. That is why the Global FXCs issued a joint statement of support at the launch of the Code in New York as well as stating their intention to make adherence to the Code a likely requirement of FXC membership.4 That would ensure the Code is embedded at the core of the FX market, but it is also important that it extends beyond that, and that there is, at the very least, an awareness of it across all market participants. A second dimension of adherence is that the BIS central banks have signalled their commitment by announcing that they themselves will follow the Code, and that they expect that their counterparties will do so too.5 To that end, the RBA will no longer transact in the FX market with those that don’t commit to adhere to the Code after its release in May. A third dimension of adherence is that we are talking to regulators in our various jurisdictions as to how they might use the Code in monitoring market conduct. In Australia, ASIC is very supportive of the development of the Code and is considering how it might utilise the Code in its market surveillance. The FCA in the UK is considering how they might incorporate the Code in the Senior Managers Regime there. Conclusion We are on track to complete the Code so that it will be released in London in May 2017. At the end of that process, for the Code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed across the full spectrum of market participants. That said, the process does not really end, because as the foreign exchange market continues to evolve, the Code will need to evolve with it. The work to date has reflected a very constructive and cooperative effort between the central banks and market participants. All of us recognise the need to restore the public’s faith in the foreign exchange market and the value of the Global Code in assisting that process and also in helping improve market functioning and confidence in the market. 1 See <www.bis.org/mktc/fxwg/gc_may16.pdf>. 2 See <www.bis.org/press/p150511.htm>. 3 See <www.bis.org/mktc/fxwg/am_may16.pdf>. See also C Salmon (2016), ‘Rebuilding Trust through the ‘FX Global Code’: Reasons for optimism’, available at <www.bankofengland.co.uk/publications/Documents/speeches/2016/speech924.pdf>, Speech given at the ACI UK Square Mile Debate, London, 7 September; and S Potter (2016), ‘The Role of Best Practices in Supporting Market Integrity and Effectiveness’, available at <www.newyorkfed.org/newsevents/speeches/2016/pot160907>, Remarks at the 2016 Primary Dealers Meeting, Federal Reserve Bank of New York, New York City, 7 September. 4 See <afxc.rba.gov.au/news/afxc-26052016.html>. 5 See <www.bis.org/press/p160526a.htm>. 3/3 BIS central bankers' speeches | reserve bank of australia | 2,016 | 11 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 15 November 2016. | Philip Lowe: Buffers and options Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Committee for Economic Development of Australia (CEDA) Annual Dinner, Melbourne, 15 November 2016. * * * I would like to thank Andrea Brischetto for assistance in the preparation of this talk. It is an honour to be able to address CEDA’s Annual Dinner. It became a tradition under the previous Governor, Glenn Stevens, to speak at these dinners about prosperity: what it looks like and how Australia might continue to secure it in the uncertain world in which we live. This is a tradition that I would like to continue. I could understand why you might not have guessed that looking at the title of my remarks this evening: ‘Buffers and Options’. You might have feared that this was going to be an esoteric talk about finance. But that is not what I have in mind. Instead, I chose this title because it summarises the one element of securing prosperity that I want to focus on tonight. Glenn spoke in detail about the various things that we can do to lift our average growth rate. Rather than repeating these, I would like to focus on another element of the challenge. And that is managing risk and ensuring resilience. To provide some context I would like to begin with two observations. The first is that Australia’s economic success over recent decades reflects both the underlying fundamentals and our ability to ride out various shocks. The fundamentals that have helped us are well known. They include our openness to trade and investment, our generally favourable demographics, our diverse and talented people, our abundance of natural resources, our ability to undertake structural reform to boost productivity and our links with the fast-growing Asian region. But also important to our prosperity is the fact that over the past quarter of a century, our economy has not been seriously derailed by economic shocks. After all, nothing undermines prosperity like a severe recession in which large numbers of people lose their jobs and see their wealth decline. It is not as if there has been a shortage of shocks that could have derailed us. There was the Asian crisis, the bust of the US tech boom and the global financial crisis. We also experienced a once in a century surge in our terms of trade and the subsequent decline. The point is that we have been able to ride out these and other shocks without too much difficulty. In part this is because of the flexibility of our exchange rate, monetary policy and the labour market. We have also avoided the build-up of large financial imbalances. But this resilience is also because when the shocks hit we have had buffers to absorb them. Because of these buffers, we had options that not all other countries have had. The second observation is that today many business people tell us they feel the heavy weight of uncertainty. The long list of factors we hear includes: uncertainty about the transition in the Chinese economy; the future direction of technology; the political environment, both abroad and at home; the impact of high debt levels on future consumer demand; and uncertainty about where the extraordinary global monetary expansion will ultimately end. Understandably, when people feel uncertain, they sometimes feel that it’s best to delay making decisions, especially if those decisions are difficult to reverse. We want to seek out more information before proceeding. We want to wait. So, to draw these two observations together: Australians have managed pretty well over the past quarter of a century, but we feel a bit uncertain about the future. 1 / 11 BIS central bankers' speeches In my view, despite the uncertainties, we should still be looking forward to the future with some optimism. Here in Australia, with our long track record of good economic growth and our demonstrated ability to adjust to a changing world, we have a set of advantages that not all countries have. Our collective challenge is to capitalise on those advantages. Ensuring a strong focus on lifting productivity is surely the key here. As we work out how to do this, though, we obviously can’t ignore the uncertainties. But neither can we let those uncertainties force us to retreat, to withdraw from the world. If we do this, then we, and our children, will be poorer as a result. Rather, we need to deal with, and prepare for, those uncertainties. This brings me back to the title of my remarks, ‘Buffers and Options’. Part of our preparation is to ensure that we have adequate buffers in place to deal with future shocks wherever they come from. These buffers provide us with options when challenges arise. I would like to talk about buffers in three broad areas: the financial system, the fiscal arena and household finances. Financial System One area where it is particularly important to have adequate buffers is in the financial sector. The financial sector can either act as a cushion for adverse shocks or it can act as an amplifier. Which one it turns out to be depends upon how well the system is prepared to deal with bad events. If the system has skimped on liquidity and is carrying too little capital, then it is likely to amplify shocks. Conversely, if the financial system has adequate buffers, it is better able to support the economy in difficult times. The aftermath of the global financial crisis is a good example of what can happen. This chart (Graph 1) shows how bank lending has grown – or in the case of Europe, contracted – since the financial crisis in 2008. Many banks in Europe and the United States simply did not have large enough buffers for the events that unfolded. Even today, capital levels remain an issue for some European banks. Insufficient capital means that some banks are constrained in their ability to provide finance and helps explain why banks have not taken advantage of the European Central Bank’s offer to lend them money at an interest rate below zero. The European economy has suffered as a result. In the United States, the picture is more positive, partly because there were more successful efforts early on to rebuild the buffers in the system. 2 / 11 BIS central bankers' speeches In Australia, it has been a different story. The banking system did have the capacity to support the economy during the global crisis, although it is important to point out that it did this with the assistance of the Australian Government through various guarantee schemes following the freezing of global capital markets. Around the world, the experience of recent years has rightly caused banks and their regulators to think again about how large the buffers should be. And the answer has been that they should be larger than they were before. This has been true in Australia too, despite the starting point here being better than in many other countries. Since the beginning of 2015, the major banks have raised around $28 billion from new equity and retained earnings, significantly increasing their capital relative to their assets (Graph 2). Banks are also holding a larger share of their assets in liquid form and have changed the composition of their funding towards more stable sources (Graph 3). During 2016, liquid assets have accounted for around 20 per cent of the major Australian banks’ total assets, up from an average of around 15 per cent in the years preceding the financial crisis. Banks have also increased their use of deposits and long-term debt and reduced their use of short-term debt. 3 / 11 BIS central bankers' speeches 4 / 11 BIS central bankers' speeches These are positive developments and they provide us with an extra degree of insurance against future shocks. Of course, this insurance does not come for free. Higher capital, more liquidity and more expensive, stable funding all have a price. We need to keep an eye out to make sure that this price is not too high and that we don’t constrain the ability of the financial system to do its job. My view is that this has not been the case in Australia and that the changes have increased the resilience of our system. There is, though, a legitimate discussion to be held as to who pays the price. We see this issue frequently debated in our media. One possibility is that the cost falls on the bank shareholders in the form of lower returns on equity. Another is that it falls on borrowers in the form of higher interest rates on bank loans relative to the cash rate. Ultimately, the balance is for the market to sort out, but it would seem unlikely that the cost will fall entirely on one side or the other. Over time, shareholders and borrowers will both benefit from these larger buffers to the extent that they contribute to economic stability. The shareholders should experience less volatile returns and borrowers should be more likely to be supported during difficult times. The larger buffers provide a form of insurance to all. Fiscal Arena A second area where buffers are important is on the fiscal front. Again, the events of the past decade provide a useful illustration. 5 / 11 BIS central bankers' speeches In Europe, we saw examples of what can happen when public finances are not in order when difficult times strike. In some countries, when troubles arrived, governments felt that they had little choice other than to impose austerity measures to restore the fiscal accounts, despite the fact that these measures added to the immediate downturn in the economy. Australia, again, provides a counter example. When the shockwaves of the global financial crisis hit us, the Australian Government did have the capacity to support the economy through a fiscal expansion. This support was one of a number of factors that helped us get through this period. The ability to provide the stimulus was enhanced by the sound fiscal position that had been built up over previous years (Graph 4). While the exact nature of the stimulus remains a matter of debate, regardless of where you stand on that debate the fiscal buffers that we had did provide us with options that not all other countries had. Since the financial crisis in 2008, the budget has been in deficit and debt levels have moved higher. Under current projections, net debt is expected to peak in 2017/18 at 19.2 per cent of GDP and a balanced budget is not expected until 2020/21. This would still leave the fiscal accounts in better order than those in many other countries. Importantly, this means that fiscal policy still retains capacity to support the economy in difficult times. But this capacity is less than it once was. We have a smaller buffer than we once did and a smaller buffer means fewer options. So from a risk-management perspective, there is merit in rebuilding our buffers on the fiscal front. This is a task that can be undertaken over time and it requires difficult choices to be made. 6 / 11 BIS central bankers' speeches As Secretary to the Treasury John Fraser reminded us in a recent speech, the task is made more difficult by slow growth in nominal income.1 But it is important that we ensure our public finances are on a sustainable track. This requires a better balance to be established, over time, between recurrent spending and revenue. It is worth pointing out that this does not preclude government spending on infrastructure, where this is backed by a strong business case. Such spending can provide support for the economy and can help generate the productive assets that a prosperous economy needs. Done well, infrastructure spending is not inconsistent with establishing a better balance between recurrent spending and revenue. Household Finances The third set of buffers that I would like to talk about are those in household balance sheets. These buffers too are important as they influence how households respond to difficult economic times. Ideally, in such times, people are able to draw on their savings a bit, and perhaps even access credit, so that they don’t have to cut their consumption sharply. Of course they can do this only if their balance sheets are in reasonable shape. Again, overseas experience is relevant here. In the United States when the recession hit in 2008 some households found that they had simply borrowed too much. What followed was a period of defaults by some, less new borrowing and faster repayment of some debt. The result was a more severe downturn and a more protracted recovery than otherwise would have occurred. Given this and other experiences, we need to pay close attention to household balance sheets here in Australia too. Debt levels, relative to income, are high in Australia and are much higher than they once were (Graph 5). Currently, household debt is equivalent to 185 per cent of annual household disposable income, a record high and up from around 70 per cent in the early 1990s. If we net off the household sector’s holdings of cash and deposits the pattern looks somewhat different. It is important, though, to recognise that the households with the debt typically are not the same ones with the large deposits. 7 / 11 BIS central bankers' speeches The reasons for the large increase in household debt have been well documented. The lower nominal interest rates that followed lower inflation in the 1990s allowed people to borrow more, as did the liberalisation of the financial system. As a nation, we took advantage of these new opportunities to borrow. As a result, we ended up with both higher levels of debt and higher housing prices. Given the low level of interest rates and ongoing employment growth, most households are managing the higher levels of debt, but many feel that they are closer to their borrowing capacity than they once were and have adjusted their behaviour accordingly. Since the financial crisis, there has been a noticeable increase in the household saving rate. We are not using our houses like ATMs in the way that we were in the decade to the mid 2000s. Gone are the days when higher housing prices were a sign that we should go to the bank and borrow more to spend. One illustration of this change in behaviour is the large increase in balances held in mortgage offset accounts and redraw facilities. In aggregate, households now have balances in these accounts equivalent to 17 per cent of total outstanding housing loans, which is a buffer worth 2½ years of scheduled repayments at current interest rates (Graph 6). From the survey data we look at, we can see that over recent years more households in all income brackets have got ahead on their mortgages (Graph 7). 8 / 11 BIS central bankers' speeches 9 / 11 BIS central bankers' speeches This more prudent behaviour is a positive development. Given the high and rising levels of debt, though, we need to watch things carefully. It is important that we avoid a build-up of financial imbalances in household balance sheets. We can never know with certainty exactly what level of debt is sustainable. It depends on income growth, lending standards and asset prices. But it surely must be the case that the higher is the debt, the greater is the risk. Given this, as I said recently when explaining our monetary policy decisions, it is unlikely to be in the public interest, given current projections for the economy, to encourage a noticeable rise in household indebtedness, even if doing so might encourage slightly faster consumption growth in the short term. Conclusion So in each of the three areas I have talked about this evening – the financial sector, the fiscal arena and household balance sheets – the story is broadly similar. Stronger buffers give us more options. And more options promote stability and prosperity. If we skimp on the buffers then we expose ourselves to more risk. It is true that building these buffers does not come for free. In the financial sector, it might mean lower returns on equity or higher lending margins. In the fiscal arena, it means difficult trade-offs about recurrent spending and taxation. And in the household sector, it means consumption growth is slower for a time than it might otherwise be. But this is the nature of insurance. You pay a premium for protection against future uncertainties and to provide resilience. Of course, we need to make sure that this premium is not too high. But it is surely better to pay the insurance 10 / 11 BIS central bankers' speeches premium when the sun is shining than when the storm clouds are building or, worse still, to seek insurance when it is too late. I am very conscious that this evening I have spoken a lot about providing resilience against future shocks. Before finishing, I want to point out that I am doing so not because we are predicting difficult times ahead. The Reserve Bank’s central scenario for the Australian economy remains a relatively positive one. Instead, my focus tonight probably reflects the inherent cautiousness of a central banker. Just as the past 25 years have seen numerous shocks to the global economy, chances are, so too will the next 25 years. In the past, we have been served well by the economy’s flexibility and the buffers that we had. Being realistic, we will probably need these buffers again some time in the years ahead. At the moment, though, our economy is adjusting better than many predicted to the unwinding of the mining investment boom. Over the next year, we are expecting the economy to grow at around its potential rate, before picking up a bit in the following year. We also expect some further modest progress in lowering unemployment, although spare capacity remains. The low interest rates are helping to support the economy. And the decline in the exchange rate over recent years has assisted a number of industries. Survey measures of business conditions and consumer confidence generally remain above average. The prices for our commodity exports have also lifted since the start of 2016. As a result, for the first time in some years, Australia’s terms of trade have moved higher. This will help to boost incomes and fiscal revenues. Inflation remains low, but the latest reading did not suggest that it was moving lower still. There remain reasonable prospects that inflation will return to around average levels over the next couple of years. Finally, to repeat an earlier point, despite the uncertainty in the world, we should be looking forward to the future with some optimism. Australians can continue to enjoy a level of prosperity enjoyed by relatively few people around the world. We have a strong set of fundamentals and a demonstrated ability to adjust to a changing world. We should also take some comfort that our system retains buffers against future shocks. Strengthening these buffers makes sense in the uncertain world in which we live. Thank you. 1 Fraser J ‘Australia’s Economic and Fiscal Outlook’, available <www.treasury.gov.au/PublicationsAndMedia/Newsroom/Speeches/2016/AGFIF-Tokyo>, Address to Australian Government Fixed Income Forum, Tokyo, 21 October. 11 / 11 at the BIS central bankers' speeches | reserve bank of australia | 2,016 | 11 |
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Business Economists Conference Dinner, Sydney, 22 November 2016. | Christopher Kent: Australia's economic transition - state by state Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of Australia, at the Australian Business Economists Conference Dinner, Sydney, 22 November 2016. * * * I thank Sean Langcake and Merylin Coombs for invaluable assistance in preparing these remarks. Introduction I am grateful for the opportunity to address you all this evening. It is fitting for my final speech in my capacity as the Bank’s chief economist to be in front of such a pre-eminent group of Australia’s business economists. I want to talk about Australia’s economic transition following the end of the resources boom. My focus will be on developments affecting broader economic conditions, and the labour and housing markets more specifically. A key theme of my discussion is that aggregate, economywide variables – such as investment, unemployment or housing prices – often mask important differences across the states. Understanding those differences can give us a better appreciation of how the Australian economy is performing and is likely to evolve. Before focusing on those differences, though, I’ll start with an overview of the overall economy. About two weeks ago, we published our updated forecasts. The flow of data over recent months had been broadly in line with our earlier expectations and so the forecasts were generally little changed. The economy continues to adjust to the end of the resources boom (Graph 1). Our expectation is that GDP growth will be close to potential growth over the next few quarters and pick up to be a little above potential thereafter. The unemployment rate, which has declined over the past year by more than expected, is likely to edge just a little lower over the next two years. That implies that there will be some spare capacity in the labour market for a time. Inflation is low. In year-ended terms, we expect underlying inflation to remain around 1½ per cent for a few quarters before gradually increasing to more normal levels. That profile follows from the forecast for the growth of labour costs to rise gradually and is consistent with the medium-term inflation target. 1 / 14 BIS central bankers' speeches Two key forces shaping developments over recent years have been the large fall in mining investment and commodity prices. Mining investment has a bit further to fall, but by our estimates about 80 per cent of the adjustment is now behind us. Resource exports still have further to grow. Meanwhile, growth of activity in the non-mining sector has risen gradually over recent years. That improvement has been fostered by low interest rates and the depreciation of the exchange rate since 2013. Growth of non-mining economic activity is expected to be around average over the next two years. One notable aspect of our latest forecasts was the upward revision to the outlook for Australia’s terms of trade. Prices of bulk commodities have risen this year and contributed to a rise in the terms of trade of about 6 per cent in the June and September quarters. That’s the first rise in the terms of trade in some time. Our forecasts are for the terms of trade to remain above the low point reached earlier this year (and about 25 per cent above the average of the early 2000s before the boom). While our forecasts are uncertain and subject to various risks, the upward revision represents a marked change from the pattern of the past five years. Our assessment, based in part on liaison information, is that the improved outlook for commodity prices is not likely to lead to a noticeable pick-up in mining investment (in the near term at least). Even so, if our forecasts are right, the terms of trade will shift from the substantial headwind of recent years to a slight tail breeze providing some support to the growth of nominal demand.1 Having set the scene on the national economy, I now want to switch attention to the differences across the states. Outcomes across the country have varied in large part because the effects of the end of the resources boom are quite different across industries. The economies of the 2 / 14 BIS central bankers' speeches mining states – Western Australia and Queensland – have been most directly affected by the sizeable declines in mining investment and commodity prices over recent years. Mining investment is relatively intensive in its use of labour. Putting the mining infrastructure in place drew upon workers with a range of construction and engineering skills. It also employed people with skills that we wouldn’t normally associate with mining, in industries such as business services, transport and manufacturing. Many of those people didn’t work on site, but were based in other parts of the state (and in some cases, beyond that).2 Whether or not they were on- or off-site, people were well rewarded for their work on mining-related projects. In response to those opportunities, there was a large rise in population growth in the mining states. Much of the spending undertaken by the new and highly paid workers found its way into the local economies, further boosting economic activity. However, mining production does not require much labour, so it has not been surprising that the shift from the investment to the production phase of the resources boom has seen a decline in the growth of nominal income in the mining states and a sharp decline in population growth. Also, the large fall in commodity prices (since the peak in 2011) weighed on mining profits, wages and fiscal revenues, further dampening the growth of nominal incomes in the mining states (and beyond). At the same time, states with less exposure to mining – New South Wales, Tasmania and Victoria – have seen an improvement in their economic conditions; and, in Victoria’s case, a persistent rise in population growth. Those states have clearly benefited from the effects of low interest rates, which have boosted conditions in their housing markets and helped to support demand more generally. The decline in the exchange rate since 2013 has also aided their tradeexposed industries, including tourism, education, business services and agriculture. South Australia’s performance lies somewhere between the large mining and non-mining states. More recently, the Queensland economy has fared better than that of Western Australia, in part because the fall in mining investment has been more advanced in Queensland. In addition, Queensland has had the advantage of its sizeable exposure to the education and tourism industries. Economic conditions and business investment This ranking of the states I have just described is evident in the NAB survey of business conditions (Graph 2). Starting around four or so years ago, surveyed conditions in most states have been on an upward trend. They are now generally above average, with conditions strongest in the south-east of the country. Western Australia is the obvious exception; conditions there have declined from above average, when mining investment and commodity prices were on the rise, to well below average of late. 3 / 14 BIS central bankers' speeches A similar ranking of economic conditions is apparent in the growth rate of household consumption. Consumption growth has generally been stronger in the south-east over the past few years and weaker in the mining states (Graph 3). 4 / 14 BIS central bankers' speeches Considering these sorts of differences across the states can enhance our understanding of the behaviour of some economy-wide aggregates. Non-mining business investment provides a good example of this point. For the country as a whole, non-mining business investment has been little changed since the onset of the global financial crisis (Graph 4). Growth of non-mining business investment had been relatively strong prior to that, averaging about 10 per cent per annum over the six years to 2007/08. It has increased a little since the peak in mining investment – by an average of 3 per cent per annum. But growth has been less than might have been expected given the support to overall demand provided by low interest rates and the depreciation of the exchange rate. 5 / 14 BIS central bankers' speeches We have gone to some lengths to try to understand why non-mining business investment has been subdued over recent years.3 Prominent among the list of explanations are: a high level of uncertainty and a low appetite for risk taking within the business community; low productivity growth; and the growing importance of service industries (which are less capital intensive). While such explanations all have some merit, there’s an additional perspective that becomes apparent once we look at the differences across the states. The ABS survey of firm’s capital expenditure provides a sense of how non-mining business investment has varied across the states (Graph 5).4 It shows that non-mining business investment has been growing over the past three years in New South Wales (by an average of about 10 per cent per annum). Victoria has also seen some growth of late. The outcomes in these states accord with information from the Bank’s business liaison program; firms in these states appear willing to invest in response to stronger business conditions. Meanwhile, nonmining business investment has been little changed in Queensland for some years, while it has declined in Western Australia since the peak in the resources boom. This is broadly consistent with the behaviour of demand across the states. 6 / 14 BIS central bankers' speeches So while non-mining business investment overall has been subdued, it is not right to say that Australian businesses have been reluctant to invest. Investment has increased to some extent in parts of the country, aided by favourable financing conditions and in response to strengthening demand. But firms have not been willing to increase investment in the mining states, and have even reduced investment in Western Australia, where demand has been particularly weak. Labour market The unemployment rate has declined over the course of this year, to be about ½ percentage point below the peak in 2015. However, that decline is likely to have overstated the extent of the improvement in labour market conditions. That is because, over the same period, employment growth has moderated and part-time jobs have accounted for all the growth in employment (Graph 6). Moreover, the rate of underemployment has increased a little over the past year. That is, there has been a rise in the share of employees who would like to work more hours than they do. They represent additional spare capacity. A rising share of part-time employment has been a structural feature of the economy over recent decades, reflecting both demand- and supply-side factors.5 But the growth of full-time employment has been quite subdued since 2012, rising only briefly above its 20-year average of 1.3 per cent per annum. 7 / 14 BIS central bankers' speeches Once again, the national outcome obscures contrasting experiences across the mining and nonmining states. During the mining investment boom, full-time employment grew strongly in the mining states, whereas it was little changed across the rest of the country (Graph 7).6 Labour was going to where it was in greatest demand and being paid relatively handsomely – in both mining and non-mining sectors in the mining states (see below). 8 / 14 BIS central bankers' speeches Since 2012, however, the situation has reversed. Full-time employment in Western Australia and Queensland hasn’t increased and the unemployment rate across those two states has risen noticeably. That makes sense. From 2012, mining investment and commodity prices were in sharp decline. In addition to the retrenchment of mining-related employment, those forces have also had a noticeable knock-on effect to non-mining industries in those states, as the buoyant effects of strong growth of the population and household expenditure have been unwound in concert with conditions in the mining industry. The decline in full-time employment over 2016 appears to reflect a further decline in demand conditions within the Western Australia economy. One important part of that, the property market, has become progressively weaker, as I’ll discuss in a minute. Moreover, wages appear to be adjusting to bring wage levels back towards those of the other states (Graph 8). Part of that adjustment is occurring via a decline in wages in the mining sector relative to wages in other sectors. Liaison reports suggest that wage pressures will be quite subdued in the mining states for a time. As that adjustment occurs, it will weigh on the growth of nominal demand in the mining states. 9 / 14 BIS central bankers' speeches Interestingly, full-time employment in the non-mining states remained weak up until about 2014. Thereafter, those states have benefited not only from the decline in interest rates, but also from the positive effect on their tradable industries from the depreciation of the exchange rate that started from early 2013. The forward-looking indicators for employment – job advertisements and job vacancies – suggest that employment will grow moderately in the non-mining states in the months ahead but remain weak in the mining states. Again, like non-mining investment, the aggregate picture of employment masks some important divergences across the states. To a certain extent, the different employment outcomes across the states have been mirrored in the behaviour of unemployment rates. However, population growth has also responded to changes in demand conditions in the labour market.7 Population growth slowed quickly in the mining states from what had been quite rapid rates (Graph 9). Some of that slowdown was the natural result of temporary workers – who had helped to build the new mining infrastructure – taking their skills elsewhere as projects were completed. The other margin of adjustment wasn’t so much an outflow of residents, but rather a halting of the inflow, including from New Zealand. In any case, the slowdown in the growth of the population in the mining states has meant that the unemployment rates there have gone up by less than would otherwise have been the case. Meanwhile, population growth has picked up over recent years in the south-eastern states, in line with the improvement in measures of business conditions and demand. Changes in population growth have also had important implications for conditions in the housing market. 10 / 14 BIS central bankers' speeches Housing market As we noted in the latest Statement on Monetary Policy, conditions in the established housing market have eased relative to a year ago. Let me be clear though: that doesn’t mean that the risks associated with high levels of house prices and housing debt have diminished. It does mean that those risks are not building to the same extent as last year. That’s because housing prices are growing less quickly than they were in 2015 and housing credit growth has also slowed. Importantly, much of that change followed from the earlier actions of the Australian Prudential Regulation Authority and the Australian Securities and Investments Commission, which led to an appreciable tightening in lending standards.8 The November Statement also discussed some indicators that suggest that conditions in housing markets may have strengthened over recent months. In particular, housing price growth has picked up in Sydney and Melbourne, where auction clearance rates have increased to high levels. In addition, loan approvals to investors have increased over recent months. In contrast to Sydney and Melbourne, housing market conditions remain subdued in Perth. Prices of apartments and detached dwellings there have declined further and are around 8 per cent below the peak. Rents in Perth have also declined by about the same amount. Those changes are consistent with the weakening in general economic conditions in Western Australia. Moreover, as the graph above shows, population growth in Western Australia has declined significantly since the peak of mining investment in 2012. And yet the full extent of the decline in population growth may not have been readily appreciated by buyers and builders of housing. That would be consistent with the fact that building approvals in Western Australia actually picked up noticeably from 2012 and did not peak until 2014, which was also about the same time that housing prices and rents reached a peak in Perth. This meant that the housing supply was still 11 / 14 BIS central bankers' speeches ramping up at the same time that population growth was declining. This is apparent in the following graph, which shows the growth in the number of people in each of the large states relative to the number of new dwellings completed at that time (Graph 10). The ‘dashes’ show the average number of people per household from the various censuses.9 In Western Australia, this ratio has fallen sharply to about one additional person in the state per new dwelling completion. That’s well below the average number of inhabitants per dwelling. In other words, there are a lot of dwellings being completed relative to the needs of the slower growing populace. That is consistent with the sharp rise in vacancy rates in Perth and the adjustment to rents and housing prices. It also suggests that dwelling construction and construction employment are likely to remain subdued for some time. That is having a knock-on effect to other industries linked to the property market. These linkages are one way in which the decline in the resource sector has been extended and amplified through to other parts of the economy.10 Before concluding, I’ll make a brief observation on the difference between the strong (and rising) population growth in Victoria over recent years and the lower population growth in New South Wales. Victoria is now the beneficiary of net inward migration from each of the other states and a larger contribution from net overseas immigration, compared with its past and compared with New South Wales currently. It strikes me that it’s possible that these contrasting outcomes across Australia’s two most populated states owe in part to the relatively high cost of housing 12 / 14 BIS central bankers' speeches and longer commute times in Sydney (and its surrounding areas) compared with Melbourne.11 Also, as Graph 10 suggests, the housing supply in Victoria has expanded at a relatively brisk pace, enabling the state to accommodate the relative strong growth of its population over recent years.12 Conclusion In a country as large and diverse as Australia, the behaviour of the economy as a whole often misses important differences across the country: The modest growth of non-mining business investment over recent years masks the stronger growth in some parts of the country and declines in others. The weakness in full-time employment nationally over the past few years owes much to the subdued demand for labour in the mining states. And housing market conditions are far from uniform. Prices are falling in Perth after a ramp up in supply combined with a fall in population growth. Meanwhile, Melbourne is seeing stronger population inflows, perhaps benefiting from strong growth of supply for some years and lower prices than in Sydney. These are a few examples of how the experiences of the different states and industries can provide useful insights into the behaviour of the overall economy. The Bank puts time and resources into understanding these sorts of differences across regions and industries. We examine a range of publicly available data and build on that knowledge through our extensive liaison program. While the Bank sets monetary policy for the nation, an appreciation of the different parts gives us more confidence about our understanding of the behaviour of the whole. A key reason for the differences across the states over recent years has been the effect of the large declines in mining investment and commodity prices. These have contributed to weaker economic conditions in the mining states and, therefore, weighed on economic conditions nationally. But those forces are waning; indeed, the terms of trade have even risen of late. Hence, there are reasonable prospects for stronger growth of nominal demand in the mining states and, by extension, for the economy overall. That would contribute to a rise in domestic inflationary pressures and a gradual return of inflation to more normal levels. In conclusion, a close examination of the differences across the states can shed some light on the outlook for the Australian economy. 1 See, for example, the November 2014 Statement on Monetary Policy. 2 In 2013, the G7 economies accounted for about 25 per cent of Australia’s exports directly, compared with about 40 per cent in 2000. And while Australia trades with these economies less than in the past, they still have an important bearing on global demand and supply conditions, thereby influencing the prices of our imports and exports. 3 Kelly G and G La Cava (2014), ‘International Trade Costs, Global Supply Chains and Value-added Trade in Australia’, RBA Research Discussion Paper No 2014–07. 4 Until the September quarter national accounts are released in early December, we won’t know though what the revision to the annual figure implies for the quarterly pattern of growth. 5 The downward revision to exports reflected shifting the reference year forward (to 2012/13). Given the decline in commodity prices, this has the effect of reducing slightly the contribution of resources exports to growth. 6 This requires an estimate of imports used in mining investment. This is a rather imprecise exercise and so the estimates for non-mining activity should be considered as rough. 7 The low growth of non-mining activity seen over the second half of the 2000s was not a sign of weakness in the economy overall, at least prior to the global financial crisis. Rather, the economy was growing strongly – as 13 / 14 BIS central bankers' speeches evidenced by the declining unemployment rate – with slower growth of non-mining activity offset by rising mining activity, particularly mining investment. 8 Kent, C (2014), ‘Non-mining Business Investment – Where to from here?’, Address to the Bloomberg Economic Summit, Sydney, 16 September. 9 This is not to say that there hasn’t been a deepening in capital over time – that is, more capital per worker in both goods and services sectors. Rather, for a given increase in the number of workers, we need less investment just to keep the capital-to-labour ratio constant if a greater share of those workers are in the services sector than in the past. 10 In Brisbane, the cooling of the property market has to date been less pronounced than in Western Australia, which probably owes to the Queensland economy being a bit more diversified than that of Western Australia as well as its geographic proximity to Sydney and Melbourne. Brisbane apartment prices have fallen of late, but house prices have continued to rise. Like Western Australia, completions in Queensland are currently running ahead of the needs of the growing population based on the recent average number of inhabitants per dwelling. 11 Median housing prices in Melbourne are currently about $770,000 versus $1.077 million in Sydney. These differences don’t appear to be accounted for by differences in incomes; data from the HILDAsurvey show that in 2014, median annual household incomes were $89,865 and $87,913 in the two cities, respectively. ABS data suggest income per capita is higher in New South Wales than Victoria, but the ratio of New South Wales to Victorian income per capita is lower than the ratio of median house prices in their respective capital cities (1.16 against 1.40). Furthermore, Sydneysiders, on average, also spend a bit longer commuting to work; HILDA data from 2014 show that the average time spent commuting to work per week is 5 hours 13 minutes in Sydney and 4 hours 56 minutes in Melbourne. 12 In part, the strength of dwelling completions in Victoria might reflect that fact that Melbourne does not have the same geographic constraints that Sydney does. Also, inner-city Melbourne (but not the next ring of suburbs out) has had more liberal building regulations. For a further discussion, see RBA (2015), ‘Submission to the Inquiry into Home Ownership’, House of Representatives Standing Committee on Economics, 25 June. 14 / 14 BIS central bankers' speeches | reserve bank of australia | 2,016 | 11 |
Opening remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the CLS FX Industry Reception, Sydney, 30 January 2017. | Guy Debelle: The Global Code of Conduct for the Foreign Exchange Market Opening remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the CLS FX Industry Reception, Sydney, 30 January 2017. * * * Today I am going to talk about the Global Code of Conduct for the Foreign Exchange Market, which has been consuming a large part of my and David Puth's sleeping hours for more than 18 months. As I hope most of you know, Phase 1 of the Code was launched in May last year in New York.1 The complete Code will be released in London in a few months' time at the end of May. It is pretty easy to find. It is available via the Bank for International Settlements (BIS) website or on the Australian Foreign Exchange Committee (AFXC) website. Today I will reiterate the motivation for the work we are doing on the Code, why you all should be interested in it, and then update you on where we are at with the process and outline the way forward. Why is the work going on? As I have stated before, the foreign exchange (FX) industry has been suffering from a lack of trust in its functioning. This lack of trust is evident both between participants in the market and, at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. A well-functioning foreign exchange market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Code sets out global principles of good practice in the foreign exchange market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to restore confidence and promote the effective functioning of the wholesale FX market. The work to develop the Code commenced in May 2015, when the BIS Governors commissioned a working group of the Markets Committee of the BIS (which I Chaired until earlier this month) to facilitate the establishment of a single global code of conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the code.2 Our Working Group comprises representatives of the central banks of all the major FX centres. This work is also very much a public sector–private sector partnership. We are being ably and vigorously supported in this work by a group of market participants, chaired by David. David's group contains people from all around the world on the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and non-bank participants, drawing from the various Foreign Exchange Committees (FXCs) and beyond. Hugh Killen from Westpac is the Australian member of this group, representing the AFXC. All parts of the market are being involved in the drafting of the code to make sure all perspectives are heard and appropriately reflected. There are two important points worth highlighting: first, it's a single code for the whole industry and second, it's a global code. On the first point, the Code is replacing the existing codes of conduct that have been present in the FX market, including the ACI model code used here in Australia. Importantly, the Code covers 1/3 BIS central bankers' speeches all of the wholesale FX industry. This is not a code of conduct for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; its breadth is both across the globe and across the whole structure of the industry. Hence the Code is relevant for all of you here in this room. The way it is relevant will depend on your engagement with the market. The guidelines for appropriate conduct are relevant for the buy side as well as the sell side. On the buy side it will also help to give you guidance as to what you can reasonably expect from your counterparty as you transact your FX business. What this means in practice is that the steps different market participants take to align their activities with the principles of the Code will necessarily reflect the size, complexity, type and extent of their engagement with the FX market. As I mentioned earlier, the first phase of the Code was released in May 2016. It covers areas such as ethics, information sharing, aspects of execution and confirmation and settlement. The second phase covers further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. We have provided market participants with a number of opportunities to comment on the second phase draft. We will be sending out a fatal flaw version of the complete Code for comment next week. The distribution to market participants will be principally through the FXCs but also through other industry associations as well. Again, we are endeavouring to ensure all perspectives are appropriately reflected in the Code. The aim is for the full Code to be published in May and we are on track to achieve that. Adherence to the Code Alongside drafting the Code, we have also been devoting considerable time and effort to thinking about how to ensure widespread adoption of the Code by market participants. Clearly, that has been an issue with the various existing codes that have been in place in a number of markets over many years. It is evident that they were ignored on occasion, wilfully or otherwise. One of our central aims in drafting the Code is for it to be principles-based rather than rulesbased. There are a number of reasons why this is so, but for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. If it's not expressly prohibited or explicitly discouraged, then it must be okay seems to be the historical experience. Moreover, the more prescriptive and the more precise the code is, the less people will think about what they are doing. If it's principles-based and less prescriptive then, as I just said, market participants will have to think about whether their actions are consistent with the principles of the Code. So, we are working with the industry to produce a principles-based code of conduct rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. But we do expect the principles in the Code to be understood and adopted across the entire FX market. Our approach to adherence has a number of dimensions. We laid out our overall approach to adherence to the Code in New York in May last year.3 One dimension is market-based adherence mechanisms. An important element of discipline should come from the market itself and we are working closely with market participants on this. The adherence to a voluntary code will only come about if firms judge it to be in their interest and take the practical steps to ensure the code is embedded in their practices. Firms will need to take practical steps such as training their staff and putting in appropriate policies and procedures. We have provided a draft Statement of Commitment for firms to 2/3 BIS central bankers' speeches publicly demonstrate their adherence to the Code. One reason for a public demonstration is that firms are more likely to adhere to the Code if they believe that their peers are doing so too. Without blaming them for what occurred, more scrutiny from counterparties about how their FX transactions were being executed may have helped to reduce the incidence and severity of the market abuses that occurred in the past. FX transactions were sometimes regarded as ancillary to the core business, notwithstanding their potential impact on returns. Ultimately the success of the Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. That is why the Global FXCs issued a joint statement of support at the launch of the Code in New York as well as stating their intention to make adherence to the Code a likely requirement of FXC membership.4 That would ensure the Code is embedded at the core of the FX market, but it is also important that it extends beyond that, and that there is, at the very least, an awareness of it across all market participants. A second dimension of adherence is that the BIS central banks have signalled their commitment by announcing that they themselves will follow the Code, and that they expect that their counterparties will do so too.5 To that end, the RBA will no longer transact in the FX market with those that don't commit to adhere to the Code after its release in May. A third dimension of adherence is that we are talking to regulators in our various jurisdictions as to how they might use the Code in monitoring market conduct. In Australia, ASIC is very supportive of the development of the Code and is considering how it might utilise the Code in its market surveillance. The Financial Conduct Authority (FCA) in the UK is considering how they might incorporate the Code in the Senior Managers Regime there. Conclusion We are on track to complete the Code so that it will be released in London in May. At the end of that process, for the Code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed across the full spectrum of market participants. That said, the process does not really end, because as the foreign exchange market continues to evolve, the Code will need to evolve with it. The work to date has reflected a very constructive and cooperative effort between the central banks and market participants. I would particularly like to acknowledge the enormous time and energy that David has contributed. All of us recognise the need to restore the public's faith in the foreign exchange market and the value of the Global Code in assisting that process and also in helping improve market functioning and confidence in the market. 1 See www.bis.org/mktc/fxwg/gc_may16.pdf. 2 See www.bis.org/press/p150511.htm. 3 See www.bis.org/mktc/fxwg/am_may16.pdf. See also C Salmon (2016), ‘Rebuilding Trust through the “FX Global Code”: Reasons for optimism’, available at www.bankofengland.co.uk/publications/Documents/speeches/2016/speech924.pdf, Speech given at the ACI UK Square Mile Debate, London, 7 September; and S Potter (2016), ‘The Role of Best Practices in Supporting Market Integrity and Effectiveness’, available at www.newyorkfed.org/newsevents/speeches/2016/pot160907, Remarks at the 2016 Primary Dealers Meeting, Federal Reserve Bank of New York, New York City, 7 September. 4 See afxc.rba.gov.au/news/afxc-26052016.html. 5 See www.bis.org/press/p160526a.htm. 3/3 BIS central bankers' speeches | reserve bank of australia | 2,017 | 2 |
Dinner remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the A50 Australian Economic Forum, Sydney, 9 February 2017. | Philip Lowe: Dinner remarks to A50 Australian Economic Forum Dinner remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the A50 Australian Economic Forum, Sydney, 9 February 2017. * * * I would like to offer you all a very warm welcome to Sydney for the A50 Forum. To those of you who have travelled to our shores from afar, thank you for visiting. I am confident that you will find your investment in time a worthwhile one. In just a short period, you will hear from the leaders in the worlds of politics, business, the policy institutions and the investment community. You will find an openness and transparency that is not always seen elsewhere around the world and you will experience a genuine desire to share perspectives. You also find a country that is prosperous and wealthy; Australians enjoy a standard of living that relatively few people around the world enjoy. You find a country that has grown consistently for some decades now, despite a pretty volatile global environment. Australia’s year-ended growth rate has been in positive territory since 1991. You find a country that has a strong and stable banking system. We have deep and liquid financial markets. The public here question why banks are so profitable, not why they performed so badly during the global financial crisis. You find a country that is well placed to benefit from growth in Asia, not only because of our natural resources base, but also because of stronger demand for our food and a wide range of services. You find a country with a growing and diverse population and one that has a high degree of social cohesion. Our population has recently been growing at around 1½ per cent a year, and around 40 per cent of us were either born overseas or have one parent born overseas. This brings a dynamism that isn’t there in countries with stagnant and less diverse populations. You also find a country with strong public institutions and whose economy is resilient and flexible. We have a demonstrated capacity to address our problems and to adjust to the changing world that we live in. In the past decade, our flexibility has meant that we have been able to maintain economic stability through the biggest investment boom in the resources sector in more than a century, and the subsequent unwinding of that boom. You also find a country with positive interest rates and a conventional monetary policy framework. The central bank is independent, analytical and pragmatic. Our inflation target is focused on medium-term outcomes. This approach means that we have the flexibility to pursue our price stability objective while taking into account developments in balance sheets in a way that can be difficult to do in more rigid monetary policy frameworks. So that is Australia. Welcome. There is a lot to like here. In the spirit of openness and transparency though that I mentioned a moment ago, we are not without our challenges. I will talk about a few of those in a moment. I first want to say a few words about openness to trade and investment and its role in Australia’s prosperity. 1/4 BIS central bankers' speeches Australia is a country that has benefited greatly from the open international trading system. Our ability to sell to the rest of the world goods and services that we can produce really well has boosted our living standards. We also benefit from being able to buy goods produced overseas. And the need to compete with others is one of the things that leads us to strive to do things better. Australians have also benefited from the relatively free flow of financial capital. Year after year, for more than two centuries now, capital from the rest of the world has helped build our country. If we had had to rely on just our own resources, we would not be enjoying the prosperity that we do today. Our asset base and our productive capacity would be lower, and so too would our standard of living. As investors, Australians have also benefited from being able to diversify our portfolios by buying foreign assets and by building strong businesses overseas. So, again, that is Australia. We provide a very good illustration of how a medium-sized country that is committed to an open international order, has a strong role for markets and a floating exchange rate, a largely open capital account and a dynamic and innovative financial sector can prosper in today’s complex world. I promised openness and transparency. So now to some of the issues, or challenges, that we face. The first is to reinvigorate productivity growth. Australia, like many other advanced economies has experienced slower productivity growth over the past decade. In our case, this has been partly due to a large increase in mining investment in response to soaring commodity prices. In recent years though, as the new production made possible by all this investment has come on stream, the productivity figures have improved. This is clearly good news, although underlying productivity growth remains relatively modest. A number of structural factors are at work here. If we do not address these factors, then we will have to adjust to noticeably slower growth in our average incomes than we have become used to. In some ways, this adjustment has already started and it is proving difficult. On the more positive side, there is no shortage of things that could be done to lift our performance. The challenge is that most of these ideas require difficult political trade-offs. A related challenge is how best to capitalise on the opportunity that the economic development of the Asian region provides. We have benefited from the surge in commodity prices driven by the rapid industrialisation of China, and from the increased demand for our food products, tourism, education and other services as incomes in Asia have grown. But it is a competitive world out there, and other countries see these opportunities too. So we need to find ways of building upon our strengths to bring goods and services to growing Asian markets at competitive prices. Lifting our productivity is a good place to start. A third issue is the task of providing adequate high-quality infrastructure to help our citizens be as productive as they can and enjoy a high quality of life. As I said earlier, our population is growing strongly which is a source of dynamism for our economy. But this growth can put strains on our infrastructure, including on transport infrastructure. These strains can reduce public support for a growing population. They can also impair our ability to compete and to be as productive as we can be. Good transport infrastructure, for example, opens up opportunities for people and opens markets. It also improves communities. Investment in transportation infrastructure can also play an important role in addressing housing affordability, which is an increasingly important issue. Infrastructure investment does of course need to be paid for. The positive news here is that there is no shortage of finance for the right projects. The task we face then is to identify the best possible projects, harness the planning capacity of government, design the best deal structures to attract private finance where it makes sense to do so, make sure that the construction process is as efficient as possible and price use appropriately. These are challenging things to do, but they are not beyond our capabilities. 2/4 BIS central bankers' speeches The final issue that I will mention this evening is that of ensuring that our public finances are on the right track. Australia has a good historical record here. Net government debt, as a share of GDP, is still low, although it is higher than it used to be. Our good record has provided us with a form of insurance. It meant that when difficult times did strike last decade, fiscal policy had the capacity to play a stabilising role. We had options that not all other countries enjoyed. Looking forward, we need to make sure that we continue to have this insurance. We can do this by rebuilding our fiscal buffers. This too is a challenging thing to do, particularly given the additional demands being placed on government. A related complication is that simultaneously we need to make sure that that our tax system is internationally competitive. One example of this complication is in the area of corporate tax, where there is a form of international tax competition going on in an effort to attract foreign investment. Like other countries, we face the challenge of responding to this, while achieving a balance between recurrent spending and fiscal revenue. So those are some of the issues we face. Of course, there are others too. No doubt you will discuss these over the course of this conference. I would like now to turn to the near-term outlook for the Australian economy. The Reserve Bank will be releasing updated detailed forecasts tomorrow in our quarterly Statement on Monetary Policy. For 2017 and 2018, these forecasts will show little change from our earlier forecasts. Over the next couple of years we expect GDP growth to be around the 3 per cent mark. In both years it will be boosted by a significant pick-up in LNG production. And the headwinds that we have been experiencing from the unwinding of the biggest mining investment boom in a century will blow themselves out. Indeed, we are already around 90 per cent of the way through the fall from the peak to expected trough in mining investment. Another headwind we have had over recent years – that is the decline in our terms of trade – has already stopped. Since earlier last year, a rise in global commodity prices has provided a boost to our national income. And the improvement in the global economy since late last year should also help us. So, with the end of the unwinding of the mining investment boom in sight, the economy is in reasonable shape. Unexpectedly, GDP did fall in the September quarter last year, but this largely reflected a confluence of temporary factors. We expect that in the December quarter, the economy returned to reasonable growth. Inflation remains low, running at around 1½ per cent in both headline and underlying terms. Importantly, inflation is not expected to fall further. Instead, our central forecast is for underlying inflation to gradually rise over the next couple of years, and for headline inflation to increase a bit more quickly, boosted by increases in oil and tobacco prices. We continue to pay close attention to the housing market and to household balance sheets. The picture varies widely across the country. Prices for houses in Sydney and Melbourne are rising strongly, but apartment prices in some cities, including Perth and Brisbane have fallen. The population is growing strongly, but there is a large number of additional dwellings to come onto the overall market this year. Growth in rents is weak, but vacancy rates in most markets are not unusually high. And investor demand looks to have strengthened in the closing months of 2016. So it is a complex picture. One reason for trying to understand this complex picture is that the level of household debt is relatively high. Overall, households are coping reasonably well with this. But there are clearly risks. So it is a positive development that over the past couple of years, banks have tightened their lending standards in some areas. This tightening was partly prompted by the supervisory measures put in place by the prudential regulator, APRA, and the Reserve Bank and APRA continue to work closely together monitoring developments. 3/4 BIS central bankers' speeches Another issue that we are paying close attention to is developments in the labour market. Employment growth slowed over 2016 and the growth that did take place was almost entirely in part-time employment. As is the case with the housing market, conditions vary across the country. Looking forward, the number of job vacancies and job ads suggest that some strengthening in employment growth might be in prospect. Our central forecast though is for the unemployment rate to remain close to its current level for some time to come. In summary then, the Bank’s central scenario is for some pick-up in economic growth and for inflation to move gradually higher. As always, though, there are risks around that outlook. As our record demonstrates, our economy does have a degree of resilience and flexibility that has allowed us to maintain stability during a pretty difficult time in the global economy. There is no reason that this can’t continue. But we do need to continue to build that resilience, while we take advantage of the considerable advantages that we have as a nation. Thank you. Welcome again. I hope you enjoy your time in Australia. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,017 | 2 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Australia-Canada Economic Leadership Forum, Sydney, 22 February 2017. | Philip Lowe: Australia and Canada – shared experiences Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Australia-Canada Economic Leadership Forum, Sydney, 22 February 2017. * * * I would like to thank Andrea Brischetto for assistance in the preparation of these remarks. Thank you for inviting me to address this year’s Australia-Canada Leadership Forum. It is a real pleasure for me to be here. The original plan for this session was to have Bank of Canada Governor, Steve Poloz, also speak. But the timing of the Bank of Canada’s next regular monetary policy meeting has meant that this wasn’t possible. Like us, the Bank of Canada has a blackout period around their policy meetings. So this means that I will need to wait for a future occasion to welcome Governor Poloz to Australia. The Bank of Canada and the Reserve Bank of Australia enjoy a very warm relationship. Many of the issues we face are similar and our perspectives are often very close to one another. This is partly because of the similarities in our economies. But it is also because Australians and Canadians are both pragmatic and open-minded people and we don’t take ourselves too seriously. So, there is a natural affinity. On the economic front, we are both medium-sized trading nations. We are both rich in natural resources. We have both had to come to terms with volatile prices for our key exports. We both have strong and resilient banking systems. We both have floating exchange rates and we operate flexible inflation targets. We are both attractive places for non-residents to invest their savings. We both have growing populations. And we both have had to deal with very large increases in housing prices in some of our cities. With all this in common, it is not surprising that we find much to talk about and experiences to share. Australia and Canada are also both countries that have benefited greatly from international trade. We are both strong supporters of a rules-based open international trading system. Too often these days, a commitment to open international trade, integration into global capital markets, a strong role for markets and a dynamic financial sector are seen as liabilities, not as assets. Australia and Canada provide strong counter examples. We show that openness can deliver both prosperity and resilience. We both enjoy standards of living that relatively few people elsewhere in the world enjoy. And while our economies have had their ups and downs, they have also proved to be pretty resilient. Australians and Canadians also understand that the benefits from openness can fall unevenly across our communities. We recognise that while openness makes the size of the pie bigger, it can also affect the distribution of the pie in a way that our societies feel uncomfortable with. This is something that we have both tried to address and have had more success on this front than some other countries. With that introduction, the main focus of my remarks this morning is on the outlook for the Australian economy. I would like to talk about this outlook in the context of three issues that I hope will have strong resonance with the Canadians in the audience. The first of these is the cycle in investment in the resources sector. The second is developments in the housing market and household borrowing. And the third is inflation targeting in a low inflation, low interest rate environment. 1 / 12 BIS central bankers' speeches The Outlook The RBA released its latest economic forecasts a couple of weeks ago. We expect economic growth to be around 3 per cent over the next couple of years. This is a little faster than our current estimate of the potential growth of our economy. Despite this, we do not expect much change in the current rate of unemployment, which stands at around 5¾ per cent. This is because some of the above-potential growth is a result of the expansion of LNG production, which does not employ that many people. Given this outlook, we expect underlying inflation to increase, but to do so only gradually. Wage growth remains subdued, but is not expected to decline further, and spare capacity is likely to remain in the economy for some time yet. Our central forecast is for headline inflation to increase to above 2 per cent later this year, boosted by increases in oil and tobacco prices. The increase in underlying inflation is expected to be a bit more gradual. Commodities and Investment The first of the three issues that I expect will strike a resonance with Canadians is the shifts in commodity prices and investment in the resources sector. This is a major factor that has shaped economic outcomes in both our countries. While the general stories are similar, the details are different. One area of difference is the size of the movements in the prices of our main exports, summarised in the terms of trade (Graph 1). Australia’s terms of trade almost doubled over the first decade of this century and in 2011 reached their highest level since the gold rushes of the 1850s. The increase in Canada was also large in a historical context, although it was not as large as that in Australia. 2 / 12 BIS central bankers' speeches This difference reflects two factors. The first is that the prices of Australia’s main commodity exports – iron ore and coal – increased by significantly more than the price of Canada’s main commodity export, oil. The short-run supply curve in iron ore and coal tends to be very steep, so the prices for these steel-making commodities increased very sharply when Chinese investment in property and infrastructure really took off. The second factor is that commodities make up a larger share of Australia’s total exports than is the case for Canada. Both of our countries have also experienced a pronounced cycle in mining investment. Not surprisingly, reflecting the larger movement in our commodity prices, the cycle has been bigger in Australia. Here, mining investment went from 2 per cent of GDP in the early 2000s to 9 per cent in 2012 (Graph 2). Another difference with Canada is that our main export partner, China, has grown at an average rate of almost 10 per cent over this period, compared with just 2 per cent average growth in Canada’s main export partner, the United States. 3 / 12 BIS central bankers' speeches Both our countries accommodated the increase in mining investment without overheating. Our flexible exchange rates played an important role here. Given the larger cycle in mining investment here, the impact on the rest of the economy has been more pronounced. While many parts of our economy did well from the boom in mining investment, others did not as they dealt with the higher exchange rate and found it difficult and more expensive to hire workers. One illustration of this broad impact is the substantial decline in Australia in non-mining investment as a share of GDP from the mid 2000s (Graph 2). By way of contrast, Canadian non-mining investment has shown much less variation. For some time, a major factor shaping our forecasts for the Australian economy has been a rebalancing of investment between the resources and non-resources sectors. We estimate that the decline of mining investment back to normal levels is around 90 per cent done. So this headwind, which has been weighing on GDP growth for some time, will blow itself out before too long. Another headwind we have had for some years is the fall in commodity prices, but this has turned into a gentle tailwind since mid last year. Since then the prices of all our main commodity exports have risen. This is good news for us, although we are not expecting the higher prices to lead to the type of pick-up in investment in the resources sector that might once have occurred. There has already been a very large expansion in supply capacity and we expect some unwinding of the recent increase in prices as supply increases. The higher prices, though, are providing a boost to our national income and this is expected to have some flow-through effects to the rest of the economy. 4 / 12 BIS central bankers' speeches The other part of the story has been the expected pick-up in non-mining investment. This pick-up has been a long time coming. As in Canada, the picture is complicated by significant differences across regions. In those parts of Australia where mining investment has been declining, nonmining investment has also been falling because of the significant spill-over effects (Graph 3). Elsewhere, the picture is more encouraging. Non-mining investment has now picked up in New South Wales and Victoria. Survey measures of capacity utilisation have increased and so too have broader-based measures of business conditions. So while the near-term outlook for nonmining investment for the country as a whole remains subdued, we continue to forecast a pickup later in the forecast period. Housing and Borrowing I would now like to turn to a second issue that I think will strike resonance with Canadians: housing prices and borrowing. This is an issue that is discussed a lot in both our countries. We have both had strong housing markets over recent years and there are concerns about the level of household indebtedness. There are some similarities in the factors at work. One is that our populations have been growing quickly for advanced industrialised countries. In Australia, population growth has averaged 1.7 per cent over the past decade, while in Canada it has averaged 1.1 per cent. Over the past couple of years the growth rates have moved closer together. 5 / 12 BIS central bankers' speeches Another similarity is that there has been strong demand from overseas residents for investments in residential property, particularly in our wonderful Pacific-rim cities. Not only are these cities attractive places to live, but we also offer investors security of property rights and economic and financial stability. Given the strong demand and its impact on prices in some areas, some state and provincial governments have recently levied additional taxes on foreign investors in residential property. Our housing markets have also been affected by the global monetary environment. We both run independent monetary policies, but the level of our interest rates is influenced by what happens elsewhere in the world. With interest rates so low and our economies being resilient, it is not so surprising that people have found it an attractive time to borrow to buy housing. 6 / 12 BIS central bankers' speeches Another characteristic that we have in common is that at a time of strong demand from both residents and non-residents, there are challenges on the supply side. I understand that zoning is an issue in Canada, just as in Australia. In some parts of Australia, there has also been underinvestment in transport infrastructure, which has limited the supply of well-located land at a time when demand for such land has been growing quickly. The result is higher prices. We are also both experiencing large differences across the various sub-markets within our countries. The strength in housing markets in our major cities contrasts with marked weakness in the mining regions following the end of the mining investment boom (Graph 6). 7 / 12 BIS central bankers' speeches The increase in overall housing prices in both our countries has gone hand in hand with a further pick-up in household indebtedness (Graph 7). In both countries the ratio of household debt to income is at a record high, although the low level of interest rates means that the debt-servicing burdens are not that high at the moment. 8 / 12 BIS central bankers' speeches In Australia, the household sector is coping reasonably well with the high levels of debt. But there are some signs that debt levels are affecting household spending. In aggregate, households are carrying more debt than they have before and, at the same time, they are experiencing slower growth in their nominal incomes than they have for some decades. For many, this is a sobering combination. Reflecting this, our latest forecasts were prepared on the basis that growth in consumption was unlikely to run ahead of growth in household income over the next couple of years; in other words the household saving rate was likely to remain constant. This is a bit different from recent years, over which the saving rate had trended down slowly (Graph 8). 9 / 12 BIS central bankers' speeches This interaction between consumption, saving and borrowing for housing is a significant issue and one that I know both central banks are watching carefully. It is one of the key uncertainties around our central scenario for the Australian economy. It was also cited as one of the key risks for the inflation outlook in the Bank of Canada’s latest Monetary Policy Report. We are still learning how households respond to higher debt levels and lower nominal income growth. Inflation Targeting in a Low Inflation Environment I would now like to turn to a third issue where there is some commonality of experience: that is dealing with an extended period of low inflation. For a few years now, both countries have experienced low rates of inflation (Graph 9). Many of the same factors have been at play. Wage growth has been subdued given the ongoing slack in the labour market. We have both also seen downward pressure on retail prices from intensified competition. In its latest Monetary Policy Report, the Bank of Canada noted that this was one issue affecting food prices. The same is true in Australia, but the experience here is broader, with new entrants, including overseas retailers, putting downward pressure on the prices of a wide range of goods. 10 / 12 BIS central bankers' speeches We are both expecting inflation to increase, but only gradually so. In our case, we expect the disinflationary effects of the earlier decline in commodity prices and the competitive pressures in retailing to wane. Some pick-up in wages growth is also expected, although wage increases are likely to remain below average for some time yet. Our liaison with businesses does not suggest that a pick-up in wage growth is imminent, but nor does it suggest that a further slowing is in prospect. Over recent times, both central banks have had to think about the implications for their monetary policy frameworks of sustained low inflation and rapid increases in borrowing and housing prices. Both have recently reaffirmed that inflation targeting remains the right monetary policy framework1. We have also emphasised that our inflation targets are flexible, not rigid straightjackets. In our case, the emphasis is very much on medium-term outcomes, rather than the outcome over any particular period. While there are some differences in emphasis in language, there is a high degree of commonality in our approaches. Governor Poloz has said on a number of occasions that the Bank of Canada takes a ‘risk management approach’ to monetary policy2. This strikes a very strong resonance with us at the Reserve Bank of Australia. At any point in time there are quite a few possible paths that the cash rate could follow to achieve Australia’s inflation target, which is to achieve an average rate of inflation over time of 2 point something. Consistent with the Reserve Bank Act, we set out to choose the path that, in our judgement, best promotes the welfare of the Australian people. 11 / 12 BIS central bankers' speeches In our risk management exercises, we have been seeking to balance the risks from having inflation low for a longer period against the risks from attempting to increase inflation more quickly, which would partly occur through encouraging more borrowing. If inflation is low for a long period of time, it is certainly possible that inflation expectations adjust, making it harder to achieve the objective. At the moment though, I don’t see a particularly high risk of this in Australia. The recent lift in headline inflation is helpful here and most measures of inflation expectations are within the range seen over recent decades. In relation to the risks from additional borrowing, it is possible that continuing rises in indebtedness, partly as a result of low interest rates, increase the fragility of household balance sheets. If so, then at some point in the future, households having decided that they had borrowed too much, might cut back consumption sharply, hurting the overall economy and employment. It is difficult to quantify this risk, but it is one that is difficult to ignore. As I said, our focus is on the medium term, not just the next year or so. Another consideration in thinking about the risks are the trends in the labour market. All else constant, if the unemployment rate is high and rising, the stronger would be the case for policy to pursue a quicker return of inflation to the midpoint of the target. To date, we have been satisfied that the labour market is heading in the right direction, if not as quickly as we’d like. After declining over 2015, our unemployment rate has been broadly steady, with employment growth concentrated in part-time jobs. And like the housing market, the labour market outcomes vary significantly across the country. So it is an area that we continue to watch carefully. In summary then, flexible inflation targeting with a medium-term focus remains the right monetary policy framework for Australia. In both Australia and Canada our monetary policy frameworks have played important roles in our economic stability of recent times. As I mentioned at the start of my remarks, we also share other strengths – a rich commodity base, strong and resilient banking systems, an attractive destination for foreign investment, flexible exchange rates and a commitment to openness and competitive markets. But overall, Australia and Canada provide pretty good advertisements for flexible inflation-targeting frameworks. Thank you and I look forward to your questions and comments. 1 See Statement on the Conduct of Monetary Policy for Australia and ‘Renewal of the Inflation-Control Target’, available at , for Canada. 2 See, for example, Poloz S (2015), ‘Integrating Financial Stability into Monetary Policy’, available at , Remarks at the Institute of International Finance, Lima, Peru, 10 October. 12 / 12 BIS central bankers' speeches | reserve bank of australia | 2,017 | 2 |
Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 24 February 2017. | Philip Lowe: Opening statement to the House of Representatives Standing Committee on Economics Opening statement by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the House of Representatives Standing Committee on Economics, Sydney, 24 February 2017. * * * Chair Members of the Committee Thank you for the opportunity to appear today to explain how we see the Australian economy as well as to discuss some of the work we have been doing at the Reserve Bank. At the equivalent hearing a year ago, the tone of the global economy was pretty sombre. We had seen turbulence in Chinese financial markets. Commodity and equity prices were declining. Some overseas central banks had pushed their interest rates into negative territory. And global growth forecasts were being lowered again. Twelve months on, the global economy looks to be on a firmer footing. In China, the growth target for 2016 was achieved despite the nervousness early in the year. In the United States, growth has strengthened and the economy is operating at close to full employment. And in Europe, the recovery is continuing, although it has a fair way to go in some countries. The Federal Reserve increased interest rates in December and further rises are expected this year. Elsewhere in the major economies there is no longer an expectation of further monetary easing, although some central banks are still continuing to expand their balance sheets. Commodity prices have moved higher. Long-term bond yields have also increased and most investors are no longer paying governments to look after their money for 10 years. Headline inflation has risen in most countries, and is much closer to target than it has been for some years. And forecasts for global growth have been revised up over recent months. This is the first time this has happened for quite a few years. So, overall it is a more positive picture. That is the good news. There are, though, still a number of significant risks on the horizon. In China, the growth target was achieved last year partly through a further build-up in debt especially to finance infrastructure investment and property development. This strategy was clearly helpful in the short run and it supported commodity prices, and Australia has benefited from that. But it runs counter to the Chinese authorities’ goal of addressing the high levels of debt and getting domestic finances on a more stable footing. So we can’t be sure about the longer-run implications. Recently, the Chinese authorities have taken some steps to tighten things up a bit. They have also been managing a depreciation of their currency against the US dollar and increased capital outflows as Chinese citizens send funds abroad. It’s a difficult balancing act. Turning to the United States, we can’t be confident about how things will play out. It is possible that the new administration’s policies could boost US and global growth. More infrastructure investment, tax reform and deregulation could all work to that end. On the other hand, if there were to be a retreat from the open international trading system, that would be damaging to the global economy, including to us here in Australia. We have much to lose if this were to occur. It is too early to tell which way things will go. Like others, we are in ‘wait and see’ mode. In Europe, while there have been no major problems for some time, there are still a number of faultlines. Some of these could be put under pressure in the year ahead, in many cases depending on the outcomes of elections. 1/4 BIS central bankers' speeches So there are still a number of risks in the global economy, although they no longer seem tilted to the downside. There are reasonable scenarios in which global growth picks up further and other scenarios in which it disappoints again. I would now like to turn to the domestic economy. A year ago, we were expecting the Australian economy to grow by around 2½–3 per cent in 2016. We haven’t yet received the final figures for the year, but the outcome is likely to be lower, at around 2 per cent. The September quarter was surprisingly weak, largely reflecting temporary factors. We are not expecting a repeat of this for the December quarter, with most of the available indictors suggesting a return to reasonable growth in the quarter. Looking forward, we still expect the Australian economy to grow by around 3 per cent this year and next. For most of the time since 2012 we have been facing headwinds from declining mining investment and falling commodity prices. Then, around the middle of last year, the headwind from falling commodity prices turned into a gentle tailwind as commodity prices lifted. And the headwind from falling mining investment should blow itself out before too long as mining investment returns to more normal levels. We will also benefit over the next few years from large increases in production of liquefied natural gas. Economic conditions continue to vary significantly across the country. They are weaker in those parts of the country adjusting to the lower levels of mining investment and they are stronger elsewhere. Nationally, measures of business conditions have picked up noticeably recently. For some time we have been waiting for a lift in non-mining business investment. It has been a long time coming. Encouragingly, in New South Wales and Victoria we have now seen a reasonable pick-up in investment. However, we are yet to see this in most other states, where the unwinding of the mining investment boom continues to affect the overall business climate. With the decline in mining investment coming to an end, we hope to see a broader pick-up over time. One area that we are watching closely is the cycle in residential construction activity, as the upswing has helped support the economy over recent years. The rate of new building approvals has slowed, but there is a large amount of work still in the pipeline, particularly for apartments, so we still expect some further growth in this part of the economy this year. There has, however, been some tightening in conditions for property developers in some markets. In the broader housing market, the picture remains quite complicated. There is not a single story across the country. In parts of the country that have been adjusting to the downswing in mining investment or where there have been big increases in supply of apartments, housing prices have declined. In other parts, where the economy has been stronger and the supply-side has had trouble keeping up with strong population growth, housing prices are still rising quickly. In most areas, growth in rents is low. And recently we have seen a pick-up in growth in credit to investors, which needs to be watched carefully. In terms of consumer prices, a year ago we had expected the inflation rate to remain above 2 per cent. It has turned out to be lower than this last year, at around 1½ per cent. Wage growth has been quite subdued, reflecting spare capacity in the labour market and the adjustment to the unwinding of the mining investment boom. We anticipate the subdued outcomes to continue for a while yet. Increased competition in retailing is also having an effect on prices, as is the low rate of increase in rents. We do not expect the rate of inflation to fall further. Our judgement is that there are reasonable prospects for inflation to rise towards the middle of the target over time. The recent improvement in the global economy provides some extra assurance on this front. Headline inflation is expected to be back above 2 per cent later this year, boosted by higher prices for petrol and tobacco. The pick-up in underlying inflation is expected to be more gradual. 2/4 BIS central bankers' speeches Since we appeared before this Committee last September, the Reserve Bank Board has kept the cash rate unchanged at 1.5 per cent. At its recent meetings the Board has been paying close attention to the outlook for inflation as well as two other issues: trends in household borrowing and in the labour market. One of the ways in which monetary policy works is to make it easier for people to borrow and spend. But there is a balance to be struck. Too much borrowing today can create problems for tomorrow, because debt does have to be repaid. At the moment, most households with borrowings do seem to be coping pretty well. But the current high level of debt, combined with low nominal income growth, is affecting the appetite of households to spend, and we are seeing some evidence of this in the consumption figures. The balance that is required is to support spending in the economy today while avoiding creating fragilities in household balance sheets that could cause problems for the economy later on. This is also something we need to watch carefully. Trends in the labour market are also important. As in the housing market, the picture in the labour market varies significantly around the country. Overall, the unemployment rate has been steady now for a little over a year at around 5¾ per cent. In a historical context this would have been considered a good outcome, although, today, a sustainably lower unemployment rate should be possible in Australia. The other aspect of the labour market that is worth noting is the continuing trend towards part-time employment. Over the past year, all the growth in employment is accounted for by part-time jobs. There is a structural element to this, but it is also partly cyclical. We expect that the unemployment rate will remain around its current level for a while yet. The Reserve Bank Board continues to balance these various issues within the framework of our flexible medium-term inflation target, which aims to achieve an average rate of inflation over time of 2 point something. Our judgement is that the current setting of the cash rate is consistent with both this and achieving sustainable growth in our economy. We will continue to review that judgement at future meetings. I would like to turn to some other aspects of the work we do at the Reserve Bank. In the area of payments, the Reserve Bank is continuing to work with industry on the development of the new payments infrastructure that will allow us all to move money around and make electronic payments more easily. The Bank is building part of the infrastructure that stands at the centre of this new system that will allow funds to be exchanged instantaneously so that customers can have very quick access to their funds. Our work is on schedule and is now being used in industry testing. Financial institutions are also working hard on their internal systems so that customers can take advantage of the new system. Developments look to be on track to allow the first payments to be made through this new system towards the end of the year. A related focus of the Payments System Board is the important role that new technologies can play in promoting efficiency and competition. In recent meetings the Board has discussed the opportunities that distributed ledger technology could offer in the payments system and in financial market infrastructures. And it is also interested in the potential for fintech to deliver improved customer experiences. The Board is therefore taking a keen interest in the work being done by the Australian Payments Council on digital identity and customers’ access to their banking and payments data. I hope that you have all come across the new $5 banknote, which was issued by the Bank from early September last year. The note was well received by the community. You might also have noticed that last Friday we released the design for the new $10 banknote. Like the new $5, the new $10 will have world-leading security features, including the clear top-to-bottom window and a rolling colour effect that changes as the banknote is tilted. It will also have two raised bumps to assist people with vision impairment. Just like the current $10 note, the new note will feature two 3/4 BIS central bankers' speeches of Australia’s most famous writers, Dame Mary Gilmore and Banjo Paterson. The printing presses are busy printing the new notes and they will be issued from September this year. We are also finalising the design of the new $50 banknote, which we plan to issue next year. One other matter that I would like to bring to your attention is that we are in the process of commissioning an external review of the efficiency of our operations. We want to make sure that we are continuously improving as an organisation and we are seeking outside assistance to identify opportunities for improvement. The review will be focused primarily on operational and administrative matters and not on our policy frameworks. It will commence within the next month and I will be in a position to share the key conclusions with the Committee when we meet later in the year. Finally, at previous hearings members of the Committee asked about the number of women at senior levels of the Reserve Bank. I am pleased to be able to report that we have made further progress here. Of the three assistant governors responsible for monetary and financial policies at the Reserve Bank, two are women. And women run over a third of the departments in the Bank, including those responsible for the Bank’s economic analysis function and for the implementation of monetary policy. So it’s quite a big change from days gone by when almost all of these important positions were held by men. I want to highlight these changes in the hope that they might provide some inspiration to women who are thinking of studying economics, finance and business. There are fantastic career opportunities out there and it would be great to see more women studying these disciplines, and perhaps considering a career at Australia’s central bank. We are currently working on some initiatives to encourage this, at both the school and university level. Thank you. My colleagues and I are here to answer your questions. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,017 | 3 |
Opening remarks by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Plenary Panel at the Australasian Housing Researchers Conference, Melbourne, 16 February 2017. | Luci Ellis: Opening remarks to Plenary Panel at the Australasian Housing Researchers Conference Opening remarks by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, to the Plenary Panel at the Australasian Housing Researchers Conference, Melbourne, 16 February 2017. * * * Thanks to Stephanie Parsons, Hannah Leal and Tahlee Stone for assistance with the graphs. I’d like to thank RMIT and the organisers of this conference for inviting me to participate in this session. I’m very glad to be here and to share the stage with Dr Rogers. Looking at the program, I see many interesting papers. A huge range of housing-related topics are represented, many well outside the Reserve Bank’s remit. But housing, as a sector, is crucial to a number of our core policy functions. In financial stability, my old role, housing is certainly crucial. Housing is the biggest asset most households will own and the bulk of household sector wealth. Lending against housing is also a large part of financial sector assets. Housing outcomes are therefore central both to the welfare of households and the stability of the financial system. The housing sector is also crucial on the monetary policy side, my new role. As a sector, it is especially sensitive to interest rates. It is a key part of the transmission mechanism of monetary policy. Housing prices respond to interest rates, and in turn affect household consumption through wealth and collateral effects. And the housing construction industry is one of the most interest-sensitive. The theme of this conference is ‘Housing and Inequality’. I’d like to talk about two aspects of that. First, there’s the inequality – or rather, diversity – between countries. Second, there’s the inequality represented by the distribution of housing outcomes across residents of a particular country. Institutions Matter: The Cross-country Dimension On the first, we can summarise by saying that institutions matter. Country-specific features are very important to housing outcomes, including the outcomes most relevant to monetary and financial stability policymakers. A range of institutions determine the idiosyncratic risk that households face, and thus the credit risk they pose to lenders. These include labour market institutions, the funding of health care, and the structure and generosity of the social safety net. Geographic and other factors determine the urban structure, which in turn affects the relative price of housing. We know from economic geography that as city populations rise – and the amenities that go together with that – housing prices rise even relative to the higher incomes that often go along with big-city living. So urban concentration affects macro-level variables, like the ratio of housing prices to household incomes, as well as individual-level outcomes, such as people’s lifetime housing experiences. The structure of the mortgage market matters, for example whether fixed or variable-rate mortgages predominate. These features are in turn affected by a range of tax and other institutional factors. An example of a feature quite specific to Australia is the popularity of linked offset accounts. These change the interpretation of debt data that do not adjust for balances in these accounts. They also change assessments of the resilience of the household sector to various kinds of shocks. 1 / 12 BIS central bankers' speeches Taken together, these factors suggest that we can’t assume a single value of any particular macro-level ratio exists that is ‘right’ for all countries or for all time. It depends. We can’t assume that a particular level of debt is always and everywhere sustainable. It depends on who has the debt and what kind of credit risk they pose. We can’t assume that a particular level of prices is ‘correct’ or ‘sustainable’ in all circumstances. What we can do is get some sense of the relativities between countries that you might expect, given those institutional and other differences. For example, we can reasonably expect that countries where much of the population lives in smaller, cheaper cities will have lower national aggregate ratios of housing prices to incomes than other countries. That might partly explain why the price-to-income ratio for the United States is relatively low (Graph 1). By contrast, Australia is somewhere around the middle of the pack of mid-sized countries on this metric. Similar comparisons of household debt-to-income ratios across countries also put Australia in the middle of the pack.1 The United States is lower, consistent with the lower average price-toincome ratios there. Several small European countries, such as Sweden and the Netherlands, have much higher ratios than Australia does. I would not expect or want Australia’s ratio to be as high as it is in those countries. Their institutions are different. In particular, a wider range of debt is tax-deductible in those countries, so households have less incentive to pay debt down. 2 / 12 BIS central bankers' speeches Distributions Matter: The Micro-level Dimension The concept of inequality perhaps of most interest to this conference, though, is the differences across households. The way people access housing is not the same. These distributional issues can be considered over several dimensions. We can consider the distribution of outcomes in the cross-section of households: how outcomes differ for different types of households at a point in time. We can consider outcomes for different cohorts: whether the experience of people in a particular age group changes over time. We can consider issues of intergenerational distribution: whether outcomes for people in one generation depend on the experiences of their parents. It turns out that these sorts of distributional issues matter for policy. Certainly they matter for financial stability policy. It is rarely the median borrower who defaults. Risk comes from the tails of the distribution. But even something as ‘macro’ as the transmission of monetary policy turns out to depend strongly on distributional considerations (Hughson et al 2016). So the Reserve Bank spends a lot of time and resources examining household survey data and other micro-data to inform our macro understanding; some of that work has explicitly touched on inequality as the subject of interest (Dollman et al 2015), while other work has noted the effect of macro-level developments on inequality (La Cava 2016). The rest of my talk today will cover a few interesting findings from this type of analysis. I’m not setting out to be comprehensive here, because that would not be feasible in the time available. But hopefully it will give a flavour of what’s possible and the kinds of issues we’ve looked at. Firstly, and unsurprisingly, housing ownership and housing wealth are not equally distributed across the cross-section of households. Secondly, fewer young people are home owners now than previous cohorts at the same age. This is partly about demography. If it were purely a story of people being priced out, other outcomes would be different. Finally, concerns about access to appropriate housing aren’t only about ownership. We should also think about how housing is experienced, including security of tenure. One issue of inequality that generates a lot of public discussion is whether people can purchase their own home. Housing affordability is clearly a concern more generally, because adequate shelter is so important to human welfare. But clearly there is great social interest in how that housing is delivered, who owns it, and who pays for it. Of the many inquiries into housing affordability over the past decade or so, at least two – the Productivity Commission’s 2003 Inquiry and the House of Representatives Standing Committee on Economics Inquiry in 2015 – were specifically on home ownership. At a national level, Australia actually has a home ownership rate that is neither unusually high nor unusually low. 2 Many of the countries that have higher rates seem to manage it by having very high proportions of young adults living with their parents, even into their thirties, rather than renting. But the outcomes do vary across households. We can see this in several independently collected data sets, but for today I’m going to rely mainly on the HILDA survey. Unsurprisingly, higher-income households are more likely to own their own home, whether with a mortgage or outright (Graph 2). The highest-income group are not only more likely to live in their own home; the wealth represented by their own home, net of debt, is also higher than for lowerincome and middle-income households. 3 / 12 BIS central bankers' speeches More important than income, though, is life stage. Not many teenagers or young adults are heads of households; those that are, are not that likely to own their own home.3 Over time, people do start purchasing their home. Home ownership rates rise rapidly with age, reaching 80 per cent for households headed by someone aged 55 or more (Graph 3). Housing wealth has the same pattern, largely because the older you are, the longer you have had to pay your mortgage down. 4 / 12 BIS central bankers' speeches Because higher-income households are more likely to be owner-occupiers, they are also more likely to have mortgage debt (Graph 4). This is why we say that most of the mortgage debt in Australia has been borrowed by those most able to service it. That said, the lower-income households that do have debt, tend to have quite a lot of debt relative to their incomes. Sometimes this is because they have temporarily low incomes, but overall it does speak to the need to be aware of pockets of potential stress within a more benign overall picture. 5 / 12 BIS central bankers' speeches Participation in the housing market need not be about owning your own home. Many people rent; someone else has to own those dwellings as well. In Australia, most private rental properties are owned by other households. In other words, there are not many companies operating as residential landlords. A good indication of who owns rental properties comes from looking at people who have housing debt other than debt on their own primary residence. In this graph, we have split up the share of people who have any housing debt into those who have only debt on their own home, and those who have some other kind of housing debt; most, but not all, of this second group also have owner-occupier debt. As you can see, this other property debt is even more likely to be held by high-income earners than owner-occupier debt is. The pattern of rising ownership rates for older age groups does not give everyone comfort that most people will be able to afford a home eventually. People worry that it is becoming harder to achieve home ownership at a given life stage than it used to be. This would be an issue of inequality across cohorts. It is true that home ownership rates have fallen for most age groups over time (Graph 5). The overall ownership rate has stayed fairly steady because the population is ageing. It is also true that ownership rates shifted down between 2006 and 2011; we’ll know what happened in 2016 when the Census data come out in a few months. The 25–34 age group is typically seen as the core group of first home buyers. We can see that ownership rates in this group have fallen by a bit more than 10 percentage points since the 6 / 12 BIS central bankers' speeches 1970s. But we can also see that most of the decline had already happened by the early 1990s, before the big increase in housing prices relative to incomes. What changed during that earlier period was that people started partnering and settling down later in life. The post-war Baby Boom had been characterised by an anomalously young average age at first marriage. Through the 1970s and 1980s, the normal historical pattern started to reassert itself. Ownership rates for young people declined as a result, because many people wait to settle down before they buy a home. By saying this, I’m not suggesting that people should not worry about whether households can achieve their desired housing tenure. I am suggesting that the situation is more complex than would be suggested by a single-minded focus on a single metric of affordability, such as median housing prices. Much of the commentary around the difficulty of achieving home ownership centres on the task of accumulating the deposit. It seems common to assume that everyone needs a 20 per cent deposit when they first buy. This isn’t actually true: although lenders require some deposit coming from genuine savings, it doesn’t have to be as high as 20 per cent. So it’s surprising that as housing prices have risen, the distribution of loan-to-valuation ratios – the converse of the deposit – hasn’t shifted up over time (Graph 6). If anything it has declined in the past few years for which we have data. It’s not entirely clear why this is. And because a high loan-to-valuation ratio does imply higher risk both for the borrower and the lender, it might not be such a bad thing. 7 / 12 BIS central bankers' speeches But it does suggest that, again, the situation is more complex than a simple summary statistic can capture. One reason why first home buyers haven’t needed to increase loan-to-valuation ratios might be that more of them are getting help from friends and family to accumulate the deposit. Careful analysis of the HILDA Survey dataset shows that the share of first home buyers receiving that help has been increasing over the decades, but it actually remains low (Graph 7). 8 / 12 BIS central bankers' speeches It is common to focus on the different outcomes for owners versus renters in purely financial terms. Another aspect of inequality I would like to talk about today is security of tenure. A range of different data sources confirm that although young people move more often than older people, the big difference is between renters and owners (Graph 8). A similar pattern occurs in countries such as the United States (Bachmann and Cooper 2014). 9 / 12 BIS central bankers' speeches Looking just at the group of households who can be tracked through the whole life of the HILDA survey, and who didn’t switch between owning and renting at any stage, you can also see that renters were also more likely to have moved many times in that 13-year period (Graph 9). 10 / 12 BIS central bankers' speeches Some earlier literature has suggested that transaction costs induce home owners to move less often than they might otherwise do, which makes it harder for them to take advantage of changing labour market opportunities (Oswald 1999). That effect doesn’t seem clear in Australian data, so I would not draw that conclusion here (Flatau et al 2002). Yet even without the transaction costs of selling a home – including tax, legal fees and agent commissions – we know that moving house can be disruptive and costly. So I question whether all those moves by renters were desired by those households. Many renters are happy with their current home, but are required to move because the lease expired or the landlord sold the property. If we are concerned about inequality of housing outcomes, perhaps we should focus less on the type of tenure, and more on security of tenure. That’s just a brief round-up of some of the issues we have been looking at recently. Housing issues will always be with us, and will always be important to the functions of the Reserve Bank. That’s why we value conferences like this: the diverse perspectives offered help us see the bigger picture. I’m certainly looking forward to the rest of the discussion in this session. Thank you for your time. 11 / 12 BIS central bankers' speeches Bibliography Bachmann R and D Cooper (2014), ‘The Ins and Arounds in the U.S. Housing Market’, Federal Reserve Bank of Boston Working Papers 14–3. Dollman R, G Kaplan, G La Cava and T Stone (2015), ‘Household Economic Inequality in Australia’, RBA Research Discussion Paper No 15. Flatau P, M Forbes, G Wood, PH Hendershott and L O’Dwyer (2002), ‘Home Ownership and Unemployment: Does the Oswald Thesis Hold for Australian Regions?’, Murdoch University School of Management and Government Working Paper 189. Hughson H, G La Cava, P Ryan and P Smith (2016), ‘The Household Cash Flow Channel of Monetary Policy’, RBA Bulletin, September, pp 21–30. Oswald AJ (1999), ‘The Housing Market and Europe’s Unemployment: A Non-Technical Paper', University of Warwick, mimeo, unpublished manuscript. RBA (Reserve Bank of Australia) (2015), ‘Submission to the Inquiry into Home Ownership’, House of Representatives Standing Committee on Economics Inquiry into Home Ownership, June. Yates J (2011), ‘Explaining Australia’s Trends in Home Ownership’, Housing Finance International, 26(4), pp 6–13. 1 Graphs showing this comparison are regularly published in the Financial Stability Review. 2 See Graph 3 in RBA (2015). 3 Who ‘heads’ a household is a matter of judgement. In these graphs, the head of each surveyed household is determined by applying certain criteria, in order, until a unique person is selected. These criteria are: in a registered marriage or de facto relationship (and still living together); a lone parent; the person with the highest income; the eldest person. 12 / 12 BIS central bankers' speeches | reserve bank of australia | 2,017 | 3 |
Speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Bloomberg Breakfast, Sydney, 14 March 2017. | Michele Bullock: Has the way we look at financial stability changed since the Global Financial Crisis? Speech by Ms Michele Bullock, Assistant Governor (Financial System) of the Reserve Bank of Australia, at the Bloomberg Breakfast, Sydney, 14 March 2017. * * * Good morning and thank you to Bloomberg for the invitation to speak this morning. This is my first speech as Assistant Governor Financial System. And while I have not been involved in the Bank’s Financial Stability area before, I was part of the Financial System Group when it was established in 1998 – sitting in its sister department Payments Policy. So reflecting my own recent journey in getting my head around this area, I thought today I would have a look back at how the Bank’s work on financial stability has evolved over the past 20 years and particularly since the financial crisis. I have posed the question ‘has the way we look at financial stability changed since the GFC?’ I will give you the answer up front. At the big picture level, the way we look at it hasn’t changed that much. But we are even more attuned to the tail risks than we were and more attuned to the need to take action if we sense that the risks are building. We are, as are policymakers globally, more sensitive to risk. But first a little history. Most of you will be familiar with the history of the Reserve Bank of Australia. Briefly, its genesis was in the Commonwealth Bank of Australia, which was established by legislation in 1911. In this early incarnation, the Bank only had the ordinary functions of a commercial and savings bank. But over the succeeding years it gradually took on a number of activities that are typical of central banks. It was given control over note issue in the 1920s and then progressively acquired exchange control powers and controls over the banking system. The Bank’s powers in relation to the administration of monetary and banking policy and exchange control were formalised in legislation in 1945. Then in 1959, the Commonwealth Bank was effectively split into two. The original institution became the Reserve Bank of Australia, whose role was to carry out central banking functions, while the commercial and savings bank functions were transferred to a new institution that kept the name Commonwealth Bank of Australia. Why this brief history lesson? I thought it was worth highlighting up front that the Reserve Bank has always had financial stability as one of its core functions. The focus on the activities of private banks and the ways in which they could be influenced or controlled grew in part out of the experiences of the Depression in the early 1930s and the major banking crisis in Australia in the 1890s. Since its establishment as a stand-alone central bank, there have been two key changes to the way the Reserve Bank approached its financial stability obligations. The first was in the early 1980s when, following the financial system inquiry undertaken by the Campbell Committee, the Australian financial system was deregulated. Previously banks had been heavily regulated so were limited in their ability to take risks. In the new deregulated environment, the Bank built up a banking supervision framework. Prudential standards were introduced and the focus was on the risk management frameworks of the banks. The second key change followed another financial system inquiry undertaken by the Wallis Committee. As a result of the inquiry, the banking supervision function was transferred to a new institution – the Australian Prudential Regulation Authority (APRA). The Reserve Bank, however, retained a role focusing on ‘overall financial system stability’. How did we interpret this? I think it was set out well in the Bank’s 1999 Annual Report, the first year of these new arrangements. The Bank stated that its ‘objective is to ensure that financial disturbances in any part of the financial system do not ultimately threaten the health of the economy.’ It went on to set out the foundations for financial stability: low inflation; a safe and robust payments system; efficient and smoothly functioning financial markets; and a sound framework of prudential supervision. 1/4 BIS central bankers' speeches Since then, we haven’t changed the way we interpret our mandate for financial stability. We are somewhat more explicit about recognising the potential human cost of financial instability in terms of financial distress and unemployment and are more attuned to the behavioural risks associated with risk cultures and financial innovations. But we have substantially increased our communication on financial stability issues. For example, in 1999, when we first started reporting formally on financial stability, we published 10 pages in the Annual Report, of which only around half were actually an assessment of financial stability. There were six charts – credit spreads in overseas bond markets, credit to GDP, credit growth, house prices, banks’ impaired assets and risk-weighted capital ratios. In March 2004 when we first published the Financial Stability Review, the assessment was around 40 pages, including over 40 charts, and it is now routinely between 50 and 60 pages with upwards of 60 charts. We also give a lot more speeches covering financial stability issues, such as this one. But while we publish much more detailed analysis, the substance of the core issues has not changed substantially. The global financial environment was considered in the 1999 assessment as was credit, household balance sheets, property prices, and the resilience of the banks. So how, if at all, has the GFC changed the way we look at financial stability? It hasn’t fundamentally changed the way think about financial system stability, though we now have a deeper understanding of the nature of the risks and the potential channels of contagion. We have also built significant capacity to better monitor risks both in the banking and non-bank sectors. Overall, I would say that policymakers around the world have become more alert to system-wide risks. Prior to the GFC, there was a common, but not universal, view that the system was fairly stable. While there were some concerns about growth in credit and asset prices, there were a number of plausible explanations suggesting that the stability of the global financial system would continue. Among these were the long period of global macroeconomic stability and low inflation that was expected to continue and that low yields were a natural consequence of the flow of savings from Asian economies. There were alternative, more pessimistic views centred around the view that investors were seriously underestimating risk and taking on too much leverage. But the more prevalent view seemed to be that the diversification of risk made possible by financial innovation, and the relative strength of capital and liquidity levels, would stand the system in good stead. You could say it had a ‘this time is different’ flavour. While recognising these arguments, policymakers in Australia never entirely bought into this. The experience with losses in commercial property in the late 1980s, the collapse of HIH in 2001 and the housing boom in the early 2000s perhaps made Australian regulators a little more circumspect. APRA had therefore maintained a strong supervisory focus on the Australian financial institutions. But we were also fortunate in Australia that the boom in commodity prices and substantial rise in the terms of trade through the 2000s produced a very favourable economic environment at a time when many of the major economies moved into recession. It was probably also fortuitous that there had been a bit of a shake-out in the housing market in Australia in 2004/05 so we were not in a boom phase when the GFC hit. All of these factors resulted in the Australian financial system coming out of the GFC in relatively good shape. Post-GFC, however, policymakers globally (including Australia) are more exercised about system-wide risk. This has resulted in three changes: more scrutiny of the global financial system, strengthened regulation and a greater willingness to respond when risks appear to be rising. One concrete outcome of this at the global level was the creation of the Financial Stability Board (FSB) in 2009, successor to the Financial Stability Forum (FSF). The FSF had been set up by the G7 finance ministers and central bank governors in 1999 to enhance international cooperation to promote stability in the international financial system. Australia was a member of the FSF. Following the GFC, the G20 called for the FSF’s membership to be broadened and its 2/4 BIS central bankers' speeches effectiveness to be strengthened. This resulted in the establishment of the FSB with a broader membership and mandate. Specifically, it was to promote international financial stability by coordinating national financial authorities and international standard-setting bodies as they have worked toward developing strong regulatory, supervisory and other financial sector policies. This involved assessing vulnerabilities affecting the global financial system and proposing actions to address them, promoting implementation of financial sector regulation and policies and monitoring implementation of the agreed reforms. This has taken the FSB into such areas as supervision, resolution regimes, derivatives markets, shadow banking, compensation practices, data and disclosure, and legal and accounting issues. And the FSB is actively looking for the next potential source of systemic risk. At its most recent meeting, for example, it considered issues raised by FinTech, misconduct and climate-related financial exposures. On the regulatory side, the international standard-setting bodies looked to lessons learnt from the crisis and in some cases revised their standards. The Basel Committee on Banking Supervision introduced a significantly strengthened capital and liquidity framework for banks, with additional requirements for the global systemically important banks, or G-SIBs. Minimum capital levels were increased, capital buffers incorporated, and leverage ratios and liquidity requirements introduced. Disclosure requirements in banking and the financial markets increased. Australia has followed this international move. APRA increased capital requirements, and applied the liquidity coverage ratio (from 2015) and net stable funding ratio (to commence from 2018) to larger and more complex Authorised Deposit-taking Institutions (ADIs). And it is working on implementing the recommendation of yet another financial system inquiry, undertaken by David Murray, that Australian banks’ capital ratios should be ‘unquestionably strong'. Standards covering financial market infrastructure were also strengthened and supervisory oversight increased. Central counterparties (CCPs) and securities settlement facilities generally performed well through the GFC. CCPs in particular withstood the default of Lehman Brothers, although the complete resolution was complicated and took some time. This resulted in increasing regulatory pressure for securities and derivatives to be cleared through CCPs, making them even more systemically important. Regulatory oversight increased along with this increase in importance, with attention focused on risk management and loss absorbance capability of CCPs, recovery plans and resolution in the event that the CCP was unable to recover. International work in this area is ongoing, with the FSB releasing a consultation paper on CCP resolution in February. As overseer of the stability of central counterparties in Australia, the Reserve Bank has been applying these new standards to domestically operating CCPs, the most prominent ones being the ASX CCPs for equities and derivatives. Finally, there seems to be more willingness for regulators and policymakers to take action if they see risks building. Prior to the GFC there was a school of thought that because asset price bubbles could not be detected in advance, it was better to clean up after any bust, rather than lean against the cycle with policy. This was not the only view, however, and some policymakers had argued for a number of years that there were indicators that could be used to detect financial imbalances and that in some circumstances policy settings should take these imbalances into account.1 Post-GFC, there has been some swing to this latter view. There is now more acceptance of the need to take action when system-wide risks are rising. This is reflected in the increasing use of what are commonly known as macroprudential policies. As my colleagues David Orsmond and Fiona Price note in a Bulletin article in December 2016, there is no universally accepted definition of macroprudential policy. 2 They define it as ‘the use of prudential actions to contain risks that, if realised, could have widespread implications for the financial system as a whole as well as the real economy.’ They also note that the use of such tools has increased in a number of countries post-GFC. 3/4 BIS central bankers' speeches In Australia, we see macroprudential policy as part and parcel of the financial stability framework. As we have set out on other occasions, the essence of macroprudential policy is that prudential supervisors recognise potential system-wide risks in their supervision of individual institutions and react accordingly. 3 APRA can and does take an active supervisory stance, modifying the intensity of its prudential supervision as it sees fit to address institution-specific risks, sectoral risks or overall systemic risk. A recent example might help to illustrate this. In 2014, the Australian regulators took the view that risks were building in the residential housing market that warranted attention. There was very strong demand for residential housing loans, particularly by investors. Price competition in the mortgage market had intensified and discounts on advertised variable rates were common. There also seemed to be a relaxation in non-price lending terms. The share of new loans that were interest only was drifting up and the growth of lending for investment properties was accelerating. Unsurprisingly in this environment, the growth in housing prices was strong, particularly in Melbourne and Sydney.4 The regulators judged that more targeted action was needed to address the risks – to put a bit of sand in the gears. So APRA tightened a number of aspects of its supervision. It indicated that it would be alert to annual growth in a bank’s investor housing lending above a benchmark of 10 per cent. It also set some more prescriptive guidelines for serviceability assessments and intensified its scrutiny of lending practices. ASIC also undertook a review of lending with a focus on whether lenders were complying with responsible lending obligations. There is no doubt that the actions did address some of the risks. Nevertheless, the early experience suggests that, while the resilience of both borrowers and lenders has no doubt improved, the initial effects on credit and some other indicators we use to assess risk may fade over time. We are continuing to monitor their ongoing effects and are prepared to do more if needed. Where to from here? With the GFC close to 10 years ago now and a substantial amount of regulatory reform having been undertaken, the focus is turning to implementation and taking stock of the effectiveness of the reforms. This is reflected in the FSB’s current agenda. But there is also some thinking to be done about how monetary policy considerations should factor in financial stability issues, and the role that macroprudential policies might play in addressing system-wide risks in a low interest rate environment. In conclusion, I would like to return to the question I posed at the beginning of this talk, and in fact the question I posed myself when I first came into this area a few months ago – has the way we look at financial stability changed since the GFC? While the basic way we look at financial stability has not changed, experience with the GFC reinforced the need to focus on system-wide issues. We need to spend time analysing them and thinking about whether policy responses might be required. We are still learning how best to do this. 1 Bloxham, P, C Kent and M Robson (2010), Asset Prices, Credit Growth, Monetary and Other Policies: An Australian Case Study, RBA Research Discussion Paper No 2010–06. 2 Orsmond, D and F Price (2016), ‘Macroprudential Policy Frameworks and Tools’, RBA Bulletin, December, pp 75–86. 3 Ellis L (2012), ‘Macroprudential Policy: A Suite of Tools or a State of Mind? ’, Speech at Paul Woolley Centre for the Study of Capital Market Dysfunctionality Annual; Conference, Sydney, 11 October. 4 RBA (Reserve Bank of Australia) (2014), Financial Stability Review, September. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,017 | 3 |
Speech by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, at the ACT Launch of the Women in Economics Network, Canberra, 20 March 2017. | Luci Ellis: Women in the economy and in economics Speech by Ms Luci Ellis, Assistant Governor (Economic) of the Reserve Bank of Australia, at the ACT Launch of the Women in Economics Network, Canberra, 20 March 2017. * * * Many thanks to Zoya Dhillon, Tanya Livermore and Tim Atkin for assistance with the graphs and other material in this talk, and to many other colleagues for helpful comments and suggestions. Thank you to the Women in Economics Network for the invitation to speak at its ACT launch. It is an incredible honour. It is also very pleasing to see that this network has been formed. As I’ll discuss later in my talk, economics has struggled with an image – and a reality – of being a male-dominated profession. This is true both in Australia and in many other countries, and it is more of an issue in economics than in some other quantitative disciplines. Networks such as these are instrumental in helping to break down barriers. That’s needed, because there are considerable barriers to achieving a more equal participation of both sexes in the profession, consistent with the true distribution of talent. Women in the Australian economy Before I get to the topic of the economics profession, I’d like to make some brief remarks on the story of women in the Australian economy. I can’t do this story justice in the time available, but perhaps some of the facts I highlight can help illuminate where Australia is in terms of equality of the sexes, and how we got there. Economic and social changes often come from deep structural drivers. Sometimes, they come instead from long-lasting effects of business cycle developments. It’s easy to confuse the two. Many commentators do so, pointing to structural causes, such as skills mismatch, when cyclical developments, like slow labour market recoveries after recessions, might be just as plausible. We must therefore be careful about interpreting shifts in the labour market, including changes to the pattern of male and female employment. It isn’t always clear what is deep and structural, what is cyclical and temporary, and what is initially cyclical but ends up having long-running effects. Cyclical developments can indeed have lasting implications. One particularly striking example is that recessions in Australia have resulted in permanent reductions in the level of full-time employment for teenagers (Graph 1). The technical term for this kind of path dependence is ‘hysteresis’. Another way to describe it might be that ‘extinction is forever’. There was a background trend of increased school retention, but it’s amazing how that effect was so concentrated in recessions and their aftermath. There’s a gender angle here, too, because the effect is starker for males than females. It isn’t entirely clear why that is, but it might have had something to do with decisions to employ apprentices. 1 / 14 BIS central bankers' speeches Structural, or perhaps we should say ‘non-economic’, factors can also have profound implications for economic outcomes. On the demographic side, we are seeing the effects of an ageing population, driven partly by increasing longevity, and partly by the end of the post-war baby boom and the ageing of the generation born in that boom. The end of the baby boom also saw an increase in the average age that people partnered and became parents (Graph 2). The post-war period was the anomaly here. The current median age of first parenting is only a little above where it was a century ago. If we look at Western European countries, it turns out that partnering and parenting in one’s mid-to-late twenties has been the norm for several centuries there.1 2 / 14 BIS central bankers' speeches On the social side, we see the long-lasting effects of the integration – or perhaps we should say the reintegration after the post-war period – of women into the labour force. Female labour force participation and employment has increased by around 15 percentage points since the mid 1970s, though it has levelled out more recently and is still noticeably lower than for males (Graph 3). 3 / 14 BIS central bankers' speeches Social and demographic changes are mediated through and in turn affect institutional arrangements. Australia’s unusual wage-setting system, starting from the 1907 Harvester judgement until the 1990s, was centred on a judicial process. The social presumption behind that process (until at least the late 1960s) was that men had a family to support, while women did not. (This led to much commentary about the number of non-existent wives and children being supported on men’s wages.) Unequal pay was therefore enforced by that process until the equal pay decisions of 1969 (equal pay for equal work) and 1972 (equal pay for work of equal value). It is common to assume that if wages are lifted by the powers of the state, rather than by the forces of supply and demand, employment of the affected group will fall. That is not what happened to women in the 1970s. As the graph above shows, female employment increased, participation increased, and a wider range of occupations opened to women. That outcome should be seen in the context of the substantial increase in educational attainment for both males and females in the post-war period (Graph 4). Much of that increase had already occurred before the equal pay decisions. Following those decisions, the gap between the sexes on this measure (which was never very large) narrowed noticeably, perhaps partly because equal pay increased the payoff to female education. (Free university education probably helped as well.) In fact it is now the case that women are more likely than men to have a tertiary education (Graph 5). 4 / 14 BIS central bankers' speeches 5 / 14 BIS central bankers' speeches The conclusion I draw from this is that, prior to those equal pay decisions, women were not being paid their marginal product. But employers did not respond to this cost differential by substituting male workers with cheaper female workers. Perhaps that was partly because of a (false) social presumption that female workers were less skilled. Occupational segregation also helps prevent substitution between different groups, in this case between the sexes. Lest you think that this is all old history and irrelevant to the present day, it is worth recalling that there are women who were in the workforce at the time of the equal pay decisions who are still in the workforce today or only recently retired; the second equal pay decision happened in my lifetime. It’s also important because the dynamics of these large social changes are quite slow moving. They take effect at a generational frequency. To take one example, participation rates of older workers – both male and female – have risen noticeably over the past decade or so (Graph 6). Part of this might be a response to increased employment opportunities in specific fields during the mining investment boom. And part of it might have been a response to rising pension ages and concerns that retirement savings might not be adequate. But for older women, some of the shift could also be a cohort effect. The generations of women with higher labour market participation rates than their predecessors were also more likely to remain in the labour force as 6 / 14 BIS central bankers' speeches they approached and passed conventional retirement ages. Occupational segregation is another feature of the labour market that shifts only slowly. Decisions made as teenagers affect occupational choices over one’s entire career. That’s still the case even nowadays, when people are expected to make several "career changes" throughout their working lives. And as you can see from this graph, the Australian labour force is still quite sex-segregated across different occupations; some occupations are mostly undertaken by female workers, while occupations such as trades and machinery operators are mostly undertaken by males (Graph 7). 7 / 14 BIS central bankers' speeches I don’t have time today to do justice to the huge literature examining how occupational segregation comes about or what might cause it to change.2 But one broad way to summarise the evidence is that the pattern of occupations that are male-dominated or female-dominated is largely determined by social conventions past and present. The echo of past social conventions remains in older workers’ occupational choices. There are examples of social conventions and employment patterns changing. Those of you who have seen the film Hidden Figures would now be aware that performing mathematical calculations was once considered ‘women’s work'. At that time, a ‘computer’ was a human, often a female human. That might be surprising to some people, given the overwhelmingly male-dominated mathematical professions today. A more recent example of what was once traditionally a ‘male’ occupation now employing many more women is the role of traffic management on roadwork crews. At a broader level, though, industry-level and occupation-level sex-segregation is remarkably stable from decade to decade. Across both the broad industry groupings shown in this graph and more narrowly defined specific industries, the share of females in total employment has been remarkably stable over the past decade or so (Graph 8). Where it has changed, the sexsegregation has if anything become more stark. 8 / 14 BIS central bankers' speeches And it’s hard to see how this will change much in the next decade or so, when we consider that the patterns of subject choices in higher education are not only quite sex-segregated, but have if anything become more so in recent years (Graph 9). Traditionally ‘female’ fields such as education, health and hospitality and personal services – all "caring professions" – have become slightly more female-dominated over the past decade. Similarly, IT has long been a maledominated field in this country, and current student enrolments are accentuating that trend. 9 / 14 BIS central bankers' speeches A dismally male profession? To understand and interpret these trends, it helps to have a few people around who have trained in economics. Unfortunately, both in general and for female students, economics is not exactly popular in Australia. The previous graph showed that the decline in the female share of tertiary students in management and commerce over the past decade has only been marginal, and the student population is reasonably balanced between males and females. But for economics, the share of female university students has always been much lower and appears to have fallen further more recently. Even more concerning is that total student numbers in economics appear to have fallen at our universities over the past couple of decades, though some data show a small pick-up more recently. The picture is even worse at school level. Taking New South Wales just as an example, fewer students are doing economics in Year 12, and a declining proportion of that declining number are female (Graph 10). From what we understand, when business studies subjects were introduced, they expanded at the expense of economics. Most of that shift happened in the 1990s. I can’t help wondering if the experience of the early 1990s recession, or the popular discussion at the time about ‘economic rationalism’ made economics somehow uncool. Or maybe business studies was seen as easier for students, or for teachers; or maybe general subjects are seen as better for employability. We just don’t know. At least we can say that it seems that the global financial crisis, which is considered in some quarters to represent a failure of economics as a discipline, did not have the same effect. In fact 10 / 14 BIS central bankers' speeches we hear from some students, young and old, who were inspired to study economics by the crisis. Maybe that has something to do with the small pick-up in total university student numbers recently. Of course, it is not essential to have studied economics at school to select it as a major at university. Studying mathematics can be another path. To succeed in university economics studies, studying mathematics and statistics is actually very helpful. But this decline in school economics is a disquieting picture. There is already a voluminous literature on the sex imbalance in the economics profession. Equality of the sexes is one of the areas where new data, and big data, have been instrumental in replacing pontification with evidence-based insight. We can no longer dismiss suggestions that treatment or representation of females are subject to negative biases and other disadvantages. From analysis of movie dialogue to matched-resume studies, evidence of bias now has statistical weight. One piece of positive news from these new data sets is that in US academia, at least, evidence of raw bias is no longer present in most Science, Technology, Engineering and Maths (STEM) fields. Male and female academics who publish the same number of papers will on average have the same experiences in hiring and promotion (Ceci et al 2014). However, economics is an outlier; there is still apparent bias in those hiring and promotion decisions (Ginther and Kahn 2015). In an earlier paper, the authors summarised their results by saying, ‘It seems that once men have assistant professor status in economics, they get tenure irrespective of their publications, citations or background, while women … only receive tenure based more on observable traits’ (Ginther and Kahn 2004). 3 Some other recent research suggests that part of 11 / 14 BIS central bankers' speeches the problem arises because selection committees don’t give female economists sufficient credit for their work when that work is co-authored with men (Sarsons 2016). It is therefore not surprising that economics, unlike most other technical disciplines such as statistics, has not seen much increase in the share of PhDs granted to women or other metrics of the ‘pipeline’ to senior positions. Seeing few women in senior faculty positions, it is also no surprise that economics does not attract many women even at undergraduate level. This is especially disappointing, given that economics is so important to understanding aspects of everyday life, media commentary and public policy discourse. One conclusion we can draw from this is that if there is some form of objective criteria for career progression, such as publications or profits, it is harder for unconscious biases to influence outcomes. But we also know from the same research that married men in STEM fields had better publication records on average than either single men or married and single women. This might suggest that women do not receive the same kind of spousal support of their careers, and therefore that publication records might overstate the underlying abilities of married men in academia. I do fear that organisations could do everything in their power to eliminate biases and obstacles to female participation, but that it won’t be enough, because of the presumptions operating within at least some couples. It isn’t all bad news for equality of the sexes in economics, though, at least not at the Reserve Bank. Some concerted effort and rethinking of our recruitment strategies have resulted in a marked turnaround in the share of female graduates in our intake this year (Graph 11).4 Contrary to what some people might fear, we didn’t have to lower our standards. Nor did we have to recruit candidates from outside the family of disciplines we usually recruit from, such as economics, finance, law, mathematics and statistics. Instead: 12 / 14 BIS central bankers' speeches We engaged more intensively with universities so that students knew about the Reserve Bank as a place where one can have a rewarding career in an inclusive environment. We used separate teams for shortlisting and interviewing, to reduce unconscious biases at later stages of the selection process. We moved our recruitment campaign earlier and started fast-tracking the obviously good candidates to interview and decision before deciding on the full slate of interviewees. I believe this last change was particularly important because we are competing with many other organisations for the best candidates, whether male or female. If we are later than our competitors, we never even see some candidates. By the time applications for jobs at the Reserve Bank opened, someone had already snapped them up. I believe that’s especially relevant for the female candidates, though. In a male-dominated field where many employers are trying to rectify their gender balance, everyone is competing for the same strong female candidates. Final thoughts I’ve touched on a lot of issues today, none in much detail. But I hope I have given a flavour of the complexity and the depth of the issues we face, both in economics and the economy more broadly. Equality of the sexes is essential if we are to achieve our economic potential as a nation. When someone faces bias or artificial obstacles, it holds all of us back. Overcoming those biases and unmaking those obstacles won’t be easy, either in the profession or in other workplaces. But it is certainly worth doing, for both males and females, now and in future. Thank you so much for your time. I wish the network every success. Bibliography Ceci SJ, DK Ginther, S Kahn and WM Williams (2014), ‘Women in Academic Science: A Changing Landscape’, Psychological Science in the Public Interest, 15(3), pp 75–131. Daly MC (2016), ‘You Tell Me—Stop Leaving Talent on the Table: Achieving Diversity with No Excuses’, Medium.com site, 15 December. Available at medium.com/diversity-withoutexcuses/stop-leaving-talent-on-the-table-achieving-diversity-with-no-excusesc0719c60564b#.ehll2i76w. Dennison T and S Ogilvie (2014), ‘Does the European Marriage Pattern Explain Economic Growth?’, The Journal of Economic History, 74(3), pp 651–692. Foreman-Peck J (2011), ‘The Western European marriage pattern and economic development’, Explorations in Economic History, 48(2), pp 292–309. Ginther DK and S Kahn (2004), ‘Women in Economics: Moving Up or Falling Off the Academic Career Ladder?’, Journal of Economic Perspectives, 18(3), pp 193–214. Ginther DK and S Kahn (2015), ‘Women’s Careers in Academic Social Science: Progress, Pitfalls, and Plateaus', Boston University, January, unpublished manuscript. Available at sites.bu.edu/shulamitkahn/files/2015/01/GintherKahn-SocSci-chapter.pdf. Goldin C (2016), ‘ A Pollution Theory of Discrimination: Male and Female Differences in Occupations and Earnings’, Human Capital in History: The American Record, University of Chicago Press, Chicago, pp 313–348. Hajnal J (1965), ‘European marriage pattern in historical perspective ’, in D Glass and DEC Eversley (eds), Population in History, Arnold, London. 13 / 14 BIS central bankers' speeches Sarsons H (2016), ‘Gender Differences in Recognition for Group Work’, Working Paper, unpublished manuscript. Available at scholar.harvard.edu/files/sarsons/files/groupwork.pdf. 1 The pattern of marriage and child-bearing occurring mainly when people are in their late 20s is known as the ‘Western European marriage pattern’ and has been established for several centuries in European data (Hajnal 1965). There is some suggestion that the establishment of this pattern was instrumental in subsequent economic development (Foreman-Peck 2011), although this claim is contested (Dennison and Ogilvie 2014). If the claim is true, though, one is tempted to speculate whether the post-war decline in average ages of marriage and child-bearing had something to do with the decline in productivity growth observed in the 1970s. 2 A useful recent contribution to this literature is Goldin (2016). 3 The working paper version of the article described this more succinctly: ‘It seems that men get tenure irrespective of their merit (including publications). Women get tenure only if they merit it’. 4 These figures group graduates by campaign year, not entry year: the last data point only includes staff starting in the 2017 cohort who were recruited in directly as graduates in 2016, rather than initially as summer interns in the summer of 2015/16. This is because our recruitment approach was changed for 2016, after those interns were interviewed and selected. Other central banks have had similar experiences: see, for example, Daly on the experience of the Federal Reserve Bank of San Francisco. 14 / 14 BIS central bankers' speeches | reserve bank of australia | 2,017 | 3 |
Opening remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the TradeTech FX Asia Conference (appearance via video link), Singapore, 22 March 2017. | Guy Debelle: Regulatory overview: The FX Global Code - defining the next steps towards a standard industry Code of Conduct Opening remarks by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the TradeTech FX Asia Conference (appearance via video link), Singapore, 22 March 2017. * * * Today I am going to talk about the FX Global Code. The Code is on track to be released in two months’ time at the end of May. This is a culmination of two years’ effort, involving considerable input from a sizeable number of foreign exchange market participants, both public and private. Today I will reiterate the motivation for the work we have been doing on the Code, why you all should be interested in it, and then update you on where we are at with the process and outline the way forward. As I hope most of you know, Phase 1 of the Code was launched in May last year in New York.1 The Code is pretty easy to find. It is available via the Bank for International Settlements (BIS) website or on the website of a number of foreign exchange committees (FXCs), including both the Australian Foreign Exchange Committee (AFXC) website and the Singaporean FXC. The text of the complete Code will be available in the same places from 25 May, following its public release. Why is the work going on? As I have stated before, the foreign exchange (FX) industry has been suffering from a lack of trust in its functioning. This lack of trust is evident both between participants in the market and, at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. A well-functioning foreign exchange market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Code sets out global principles of good practice in the foreign exchange market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to restore confidence and promote the effective functioning of the wholesale FX market. To that end, one of the guiding principles underpinning our work is that the Code should promote a robust, fair, liquid, open and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. The work to develop the Code commenced two years ago, in May 2015, when the BIS Governors commissioned a working group of the Markets Committee of the BIS (which I chaired until early January this year) to facilitate the establishment of a single global code of conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the Code.2 Our group comprises representatives of the central banks of all the major FX centres. Cindy Mok from the Monetary Authority of Singapore (MAS) has made a major contribution to the process, and is very much the person you should speak to in the Singapore market about the Code. The central banks of China, Hong Kong, Japan and Korea, as well as my country, Australia, are the other Asian central banks on the group. 1/5 BIS central bankers' speeches This work is also very much a public sector–private sector partnership. We have been ably and vigorously supported in this work by a group of market participants, chaired by David Puth, CEO of CLS. David’s group contains people from all around the world on the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and nonbank participants, drawing from the various Foreign Exchange Committees and beyond. All parts of the market have been involved in the drafting of the Code to make sure all perspectives are heard and appropriately reflected. There are two important points worth highlighting: first, it’s a single code for the whole industry and second, it’s a global code. On the first point, the Code is supplanting the existing codes that have been present in the FX market, including the Blue Book that is used in Singapore, and the ACI model code that is used in Australia. Importantly, the Code covers all of the wholesale FX industry. This is not a code for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; its breadth is both across the globe and across the whole structure of the industry. Hence the Code is relevant for all of you here at this conference. The way it is relevant will depend on your engagement with the market. The guidelines for appropriate conduct are relevant for the buy side as well as the sell side. On the buy side it will also help to give you guidance as to what you can reasonably expect from your counterparty as you transact your FX business. What this means in practice is that the steps different market participants take to align their activities with the principles of the Code will necessarily reflect the size, complexity, type and extent of their engagement with the FX market. As I mentioned earlier, the first phase of the Code was released in May 2016. It covers areas such as ethics, information sharing, aspects of execution and confirmation and settlement. The second phase covers further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. We have provided market participants with a number of opportunities to comment on the Code, in addition to receiving the direct input of the Market Participants Group led by David Puth. Over the past few months, drafts of the full text of the Code have been distributed to market participants for their review, principally through the various FXCs, but also through other industry associations to ensure all perspectives are appropriately reflected in the Code. Through this process, quite a few thousand comments were received. In my view, the text of the Code provides the best and most appropriate guidance we could give, given the sometimes wide range of feedback received, particularly on those small number of issues which are most controversial in the market. The most obvious example of this is ‘last look’. This issue has generated considerable passionate discussion. I would expect that discussion to continue after the release of the Code in May and that the Code might evolve as a function of that discussion. I would like to make the point that if market participants think it would be preferable for the Code to have gone further, they are welcome to go down that path in their operations. On the other hand, it would not be desirable for the converse to occur, namely for market participants’ practices to fall short of the principles described in the Code. That said, I think it is good outcome of the process that we were able to distil the points of contention down to a small number of (not insignificant) issues. Outside of a small number of contentious areas, the feedback was reflective of a widely held consensus. Market participants have recognised the Code’s aim of helping move the FX market to a better place. I will illustrate that with a couple of the areas that were addressed in the first phase of the Code, which is already in the public domain. In the first phase, topics were covered that the market was looking for guidance on sooner rather than later and that were potentially having an adverse effect 2/5 BIS central bankers' speeches on market functioning. One example of this is around information sharing, where many market participants have highlighted that they are unsure what information can be conveyed to counterparties and other market participants. While it is clear (or at least should be) that disclosing the details of a client’s order book to a counterparty is not acceptable, market participants have noted that there is much less clarity around what level of aggregation, say, is necessary in order to convey market colour appropriately. As a result, it appears some market participants are being very conservative in sharing information, which can have implications for the effective functioning of the market. This is notwithstanding the guidance provided in this area in the Global Preamble put out by the global Foreign Exchange Committee, in March 2015.3 The Global Code takes the material in the Global Preamble and fleshes it out a bit more, including with some examples of what is, and isn’t, appropriate communication, and why. Similarly, there have been diverse opinions around what is appropriate behaviour in terms of order handling. There have been some very public instances of inappropriate behaviour around order handling that have come to light in recent years. The market is seeking greater guidance as to what principles should be followed, including the different standards that may apply depending on whether an intermediary is functioning as principal or agent. This is one area that was not adequately covered in the pre-existing codes that the various FXCs had endorsed for the FX market. It is an area where we are aiming to provide the sought-after guidance. But we are not writing a procedures manual for order handling. Rather we are articulating principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manual. Our aim in articulating these principles is to provide market participants with the framework in which to think about how they handle stop-loss orders. The emphasis here is very much on the word ‘think’. The Global Code will not provide the answers to all your questions, but it should help you ask the right questions. Adherence to the Code Alongside drafting the Code, we have also been devoting considerable time and effort to thinking about how to ensure widespread adoption of the Code by market participants. Clearly, that has been an issue with the various existing codes that have been in place in a number of markets over many years. It is evident that they were ignored on occasion, wilfully or otherwise. One of our central aims in drafting the Code is for it to be principles-based rather than rulesbased. There are a number of reasons why this is so but, for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. If it’s not expressly prohibited or explicitly discouraged, then it must be okay seems to be the historical experience. Moreover, the more prescriptive and the more precise the Code, the less people will think about what they are doing. If it’s principles-based and less prescriptive then, as I just said, market participants will have to think about whether their actions are consistent with the principles of the Code. So, we are working with the industry to produce a principles-based code rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. But we do expect the principles in the Code to be understood and adopted across the entire FX market. Our approach to adherence has a number of dimensions. We laid out our overall approach to adherence to the Code in New York in May last year. 4 We will provide a more comprehensive description of the suite of mechanisms to support adherence to the Code alongside the release of the Code in May. 3/5 BIS central bankers' speeches One critical dimension is market-based adherence mechanisms. An important element of discipline should come from the market itself and we are working closely with market participants on this. The adherence to a voluntary code will only come about if firms judge it to be in their interest and take the practical steps to ensure the code is embedded in their practices. Firms will need to take practical steps such as training their staff and putting in appropriate policies and procedures. We have provided a draft Statement of Commitment for firms to publicly demonstrate their adherence to the Code. One reason for a public demonstration is that firms are more likely to adhere to the Code if they believe that their peers are doing so too. Without blaming them for what occurred, more scrutiny from counterparties about how their FX transactions were being executed may have helped to reduce the incidence and severity of the market abuses that occurred in the past. FX transactions were sometimes regarded as ancillary to the core business, notwithstanding their potential impact on returns. Ultimately the success of the Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. That is why the Global FXCs issued a joint statement of support at the launch of the Code in New York as well as stating their intention to make adherence to the Code a likely requirement of FXC membership.5 That would ensure the Code is embedded at the core of the FX market, but it is also important that it extends beyond that, and that there is, at the very least, an awareness of it across all market participants. A second dimension of adherence is that the BIS central banks have signalled their commitment by announcing that they themselves will follow the Code, and that they expect that their counterparties will do so too.6 To that end, the RBA will no longer transact in the FX market with those that don’t commit to adhere to the Code after its release in May. A third dimension of adherence is that we are talking to regulators in our various jurisdictions as to how they might use the Code in monitoring market conduct. In Australia, the securities regulator, ASIC is very supportive of the development of the Code and is considering how it might utilise the Code in its market surveillance. The Financial Conduct Authority (FCA) in the UK is considering how they might incorporate the Code in the Senior Managers Regime there. Given that we are only providing the full text of the Code to the market in May, there will be a period of time for market participants to adjust their practices where necessary (which should hopefully not be much) to be in line with the principles in the Code. This period of time might potentially be as short as six months, but no more than twelve months for the vast majority of market participants. How much effort this might require will in part depend on the nature and extent of your engagement with the FX market. In drafting the Code, we have always kept the principle of proportionality at front of mind. Conclusion We are on track to complete the Code so that it will be released in London in May. At the end of that process, for the Code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed across the full spectrum of market participants. I ask you all as participants in the foreign exchange market to familiarise yourself with the principles of the Code and verify that your operations in the market align with them. That said, the process does not really end, because as the foreign exchange market continues to evolve, the Code will need to evolve with it. The work to date has reflected a very constructive and cooperative effort between the central banks and market participants. I would particularly like to acknowledge the enormous time and energy contributed by David Puth and the Market Participants Group as well as the team of my fellow central bankers. All of us recognise the need to restore the public’s faith in the foreign 4/5 BIS central bankers' speeches exchange market and the value of the Global Code in assisting that process and also in helping improve market functioning and confidence in the market. Let me finish with three things to take away with you: Read the FX Global Code when it is released on May 25th. Adapt your business where appropriate to conform with the principles of the Global Code. Ask your FX counterparties whether they are committed to the principles of the Global Code. 1 See <www.bis.org/mktc/fxwg/gc_may16.pdf>. 2 See <www.bis.org/press/p150511.htm>. 3 See <www.rba.gov.au/afxc/about-us/pdf/global-preamble.pdf>. 4 See <www.bis.org/mktc/fxwg/am_may16.pdf>. See also C Salmon (2016), ‘Rebuilding Trust through the “FX Global Code”: Reasons for Optimism’, available at <www.bankofengland.co.uk/publications/Documents/speeches/2016/speech924.pdf>, Speech at the ACI UK Square Mile Debate, London, 21 September; and S Potter (2016), ‘The Role of Best Practices in Supporting Market Integrity and Effectiveness’, Remarks at the 2016 Primary Dealers Meeting, Federal Reserve Bank of New York, New York City, September, available at <www.newyorkfed.org/newsevents/speeches/2016/pot160907>. 5 See <afxc.rba.gov.au/news/afxc-26052016.html>. 6 See <www.bis.org/press/p160526a.htm>. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,017 | 3 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the FX Week (Australia) 2017 Conference, Sydney, 28 March 2017. | Guy Debelle: The FX Global Code of Conduct – final phase Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the FX Week (Australia) 2017 Conference, Sydney, 28 March 2017. * * * Today I am going to talk about the FX Global Code. The Code is on track to be released in two months’ time on 25 May. This is a culmination of two years’ effort, involving considerable input from a sizeable number of foreign exchange market participants, both public and private. Today I will reiterate the motivation for the work we have been doing on the Code, why you all should be interested in it, and then update you on where we are at with the process and outline the way forward. As I hope most of you know, Phase 1 of the Code was launched in May last year in New York.1 The Code is pretty easy to find. It is available via the Bank for International Settlements (BIS) website or on the website of a number of foreign exchange committees (FXCs), including the Australian Foreign Exchange Committee (AFXC) website.2 The text of the complete Code will be available in the same places from 25 May, following its public release. Why is the work going on? As I have stated before, the foreign exchange (FX) industry has been suffering from a lack of trust in its functioning. This lack of trust is evident both between participants in the market and, at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately. A well-functioning FX market is very much in the interest of all market participants. This clearly includes central banks, both in their own role as market participants but also as the exchange rate is an important channel of monetary policy transmission. In a globalised world, the foreign exchange market is one of the most vital parts of the financial plumbing. The Code sets out global principles of good practice in the FX market to provide a common set of guidance to the market, including in areas where there is a degree of uncertainty about what sort of practices are acceptable, and what are not. This should help to restore confidence and promote the effective functioning of the wholesale FX market. To that end, one of the guiding principles underpinning our work is that the Code should promote a robust, fair, liquid, open and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour. The work to develop the Code commenced two years ago, in May 2015, when the BIS Governors commissioned a working group of the Markets Committee of the BIS (which I chaired until early January this year) to facilitate the establishment of a single global code of conduct for the wholesale FX market and to come up with mechanisms to promote greater adherence to the Code.3 Our group comprises representatives of the central banks of all the major FX centres. My colleague Matt Boge at the RBA has contributed enormous time and effort to the project. This work is also very much a public sector–private sector partnership. We have been ably and vigorously supported in this work by a group of market participants, chaired by David Puth, CEO of CLS. David’s group contains people from all around the world on the buy side, including corporates and asset managers, and the sell side, along with trading platforms, ECNs and nonbank participants, drawing from the various FXCs and beyond. Hugh Killen from Westpac has been the representative from Australia on David’s group. All parts of the market have been 1/5 BIS central bankers' speeches involved in the drafting of the Code to make sure all perspectives are heard and appropriately reflected. There are two important points worth highlighting: first, it’s a single code for the whole industry and second, it’s a global code. On the first point, the Code is supplanting the existing codes that have been present in the FX market, including the ACI model code that is used in Australia. The ACI has recently confirmed its intention to utilise the FX Global Code and will make it a prerequisite for members to commit to adherence to the FX Global Code.4 Importantly, the Code covers all of the wholesale FX industry. This is not a code for just the sell side. It is there for the sell side, the buy side, non-bank participants and the platforms; its breadth is both across the globe and across the whole structure of the industry. Hence the Code is relevant for all of you here at this conference. The way it is relevant will depend on your engagement with the market. On the buy side it will also help to give you guidance as to what you can reasonably expect from your counterparty as you transact your FX business. What this means in practice is that the steps different market participants take to align their activities with the principles of the Code will necessarily reflect the size, complexity, type and extent of their engagement with the FX market. As I mentioned earlier, the first phase of the Code was released in May 2016. It covered areas such as ethics, information sharing, aspects of execution and confirmation and settlement. The second phase covers further aspects of execution including e-trading and platforms, prime brokerage, as well as governance, and risk management and compliance. We have provided market participants with a number of opportunities to comment on the Code, in addition to receiving the direct input of the Market Participants Group led by David Puth. Over the past few months, drafts of the full text of the Code have been distributed to market participants for their review, principally through the various FXCs, but also through other industry associations to ensure all perspectives are appropriately reflected in the Code. Through this process, quite a few thousand comments were received. In my view, the text of the Code provides the best and most appropriate guidance we could give, given the sometimes wide range of feedback received, particularly on those small number of issues that are most controversial in the market. The most obvious example of this is ‘last look’. This issue has generated considerable passionate discussion. I would expect that discussion to continue after the release of the Code in May and that the Code might evolve as a function of that discussion. I would like to make the point that if market participants think it would be preferable for the Code to have gone further, they are welcome to go down that path in their operations. On the other hand, it would not be desirable for the converse to occur, namely for market participants practices to fall short of the principles described in the Code. That said, I think it is a good outcome of the process that we were able to distil the points of contention down to a small number of (not insignificant) issues. Outside of a small number of contentious areas, the feedback was reflective of a widely held consensus. Market participants have recognised the Code’s aim of helping move the FX market to a better place. I will illustrate that with a couple of the areas that were addressed in the first phase of the Code, which is already in the public domain. One example of this is around information sharing, where many market participants highlighted that they are unsure what information can be conveyed to counterparties and other market participants. While it is clear (or at least should be) that disclosing the details of a client’s order book to a counterparty is not acceptable, market participants have noted that there is much less clarity around what level of aggregation, say, is necessary in order to convey market colour appropriately. 2/5 BIS central bankers' speeches As a result, it appears some market participants are being very conservative in sharing information, which can have implications for the effective functioning of the market. This is notwithstanding the guidance provided in this area in the Global Preamble put out by the global FXCs, in March 2015.5 The Global Code takes the material in the Global Preamble and fleshes it out a bit more, including with some examples of what is, and isn’t, appropriate communication, and why. Similarly, there have been diverse opinions around what is appropriate behaviour in terms of order handling. There have been some very public instances of inappropriate behaviour around order handling that have come to light in recent years. The market is seeking greater guidance as to what principles should be followed, including the different standards that may apply depending on whether an intermediary is functioning as principal or agent. This is one area that was not adequately covered in the pre-existing codes that the various FXCs had endorsed for the FX market. It is an area where we have provided the sought-after guidance. But we are not writing a procedures manual for order handling. Rather we are articulating principles that need to be taken into account. Individual firms may then take these principles and reflect them in their own procedures manual. Our aim in articulating these principles is to provide market participants with the framework in which to think about how they handle stop-loss orders. The emphasis here is very much on the word ‘think’. The Global Code will not provide the answers to all your questions, but it should help you ask the right questions. Adherence to the Code Alongside drafting the Code, we have also been devoting considerable time and effort to thinking about how to ensure widespread adoption of the Code by market participants. Clearly, that has been an issue with the various existing codes that have been in place in a number of markets over many years. It is evident that they were ignored on occasion, wilfully or otherwise. One of our central aims in drafting the Code is for it to be principles-based rather than rulesbased. There are a number of reasons why this is so but, for me, an important reason is that the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. Moreover, the more prescriptive and the more precise the code, the less people will think about what they are doing. If it’s principles-based and less prescriptive then, as I just said, market participants will have to think about whether their actions are consistent with the principles of the Code. So, we have worked with the industry to produce a principles-based code rather than a set of prescriptive regulatory standards. It will not impose legal or regulatory obligations on market participants, nor will it supplant existing regulatory standards or expectations. But we do expect the principles in the Code to be understood and adopted across the entire FX market. Our approach to adherence has a number of dimensions. We laid out our overall approach to adherence to the Code in New York in May last year. 6 We will provide a more comprehensive description of the suite of mechanisms to support adherence alongside the release of the Code in May. One critical dimension is market-based adherence mechanisms. An important element of discipline should come from the market itself and we are working closely with market participants on this. The adherence to a voluntary code will only come about if firms judge it to be in their interest and take the practical steps to ensure the code is embedded in their practices. Such practical steps would include training their staff and putting in appropriate policies and procedures. We have provided a draft Statement of Commitment for firms to publicly demonstrate their adherence to the Code. One reason for a public demonstration is that firms are more likely to 3/5 BIS central bankers' speeches adhere to the Code if they believe that their peers are doing so too. That is, an important source of pressure to adhere should come from other market participants. Without blaming them for what occurred, more scrutiny from counterparties about how their FX transactions were being executed may have helped to reduce the incidence and severity of the market abuses that occurred in the past. One reason for this lack of scrutiny was that FX transactions were sometimes regarded as ancillary to the core business, notwithstanding their potential impact on returns. This attitude seems to be in decline, though it still persists. Ultimately the success of the Code in promoting integrity and restoring confidence in the wholesale FX market lies in the hands of its participants. Another aspect of market-based adherence comes through the FXCs. The Global FXCs issued a joint statement of support at the launch of the Code in New York as well as stating their intention to make adherence to the Code a likely requirement of FXC membership.7 In Australia, a commitment to adhere to the Code will be a requirement for membership of the AFXC. That would ensure the Code is embedded at the core of the FX market, but it is also important that it extends beyond that, and that there is, at the very least, an awareness of it across all market participants. A second dimension of adherence is that the BIS central banks have signalled their commitment by announcing that they themselves will follow the Code, and that they expect that their counterparties will do so too.8 To that end, the RBA will no longer transact in the FX market with those that don’t commit to adhere to the Code. A third dimension of adherence is that we are talking to regulators in our various jurisdictions as to how they might use the Code in monitoring market conduct. In Australia, the securities regulator, ASIC, is very supportive of the development of the Code and is considering how it might utilise the Code in its market surveillance. In its recent enforceable undertakings against some local market participants, ASIC has referred explicitly to the Code. ASIC ‘encourages market participants to adhere to high standards of market practice, including those set out in the Global Code’.9 In the UK, the Financial Conduct Authority (FCA) is considering how they might incorporate the Code in the Senior Managers Regime there. Given that we are only providing the full text of the Code to the market in May, there will be a period of time for market participants to adjust their practices where necessary to be in line with the principles in the Code. Hopefully not much time should be required to do this. This period of time might potentially be as short as six months, but no more than twelve months for the vast majority of market participants. How much effort this might require will in part depend on the nature and extent of your engagement with the FX market. In drafting the Code, we have always kept the principle of proportionality at front of mind. Conclusion We are on track to complete the Code so that it will be released in London in May. At the end of that process, for the Code to be effective and for it to achieve what we want it to achieve, it will need to be accepted and endorsed across the full spectrum of market participants. I ask you all as participants in the foreign exchange market to familiarise yourself with the principles of the Code and verify that your operations in the market align with them. That said, the process does not really end, because as the foreign exchange market continues to evolve, the Code will need to evolve with it. The work to date has reflected a very constructive and cooperative effort between the central banks and market participants. I would particularly like to acknowledge the enormous time and energy contributed by David Puth and the Market Participants Group as well as the team of my fellow central bankers. All of us recognise the need to restore the public’s faith in the foreign 4/5 BIS central bankers' speeches exchange market and the value of the Global Code in assisting that process and also in helping improve market functioning and confidence in the market. Let me finish with three things to take away with you: Read the FX Global Code when it is released on 25 May. Adapt your business where appropriate to conform to the principles of the Global Code. Ask your FX counterparties whether they are committed to the principles of the Global Code. 1 See <www.bis.org/mktc/fxwg/gc_may16.pdf>. 2 See <afxc.rba.gov.au/>. 3 See <www.bis.org/press/p150511.htm>. 4 See <acifma.com/news-detail?page=1%2C0>. 5 See <www.rba.gov.au/afxc/about-us/pdf/global-preamble.pdf>. 6 See <www.bis.org/mktc/fxwg/am_may16.pdf>. See also Salmon C (2016), ‘Rebuilding Trust through the “FX Global Code’”: Reasons for optimism’, Speech given at the ACI UK Square Mile Debate, London, 21 September, available at <www.bankofengland.co.uk/publications/Documents/speeches/2016/speech924.pdf>; and Potter S (2016), ‘The Role of Best Practices in Supporting Market Integrity and Effectiveness’, available at <www.newyorkfed.org/newsevents/speeches/2016/pot160907>, Remarks at the 2016 Primary Dealers Meeting, Federal Reserve Bank of New York, New York City, 7 September. 7 See <afxc.rba.gov.au/news/afxc-26052016.html>. 8 See <www.bis.org/press/p160526a.htm>. 9 See <www.asic.gov.au/about-asic/media-centre/find-a-media-release/2017-releases/17–065mr-asic-accepts- enforceable-undertakings-from-westpac-and-anz-to-address-inadequacies-within-their-wholesale-fxbusinesses/>. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,017 | 3 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, Reserve Bank Board Dinner, Melbourne, 4 April 2017. | Philip Lowe: Remarks at Reserve Bank Board Dinner Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, Reserve Bank Board Dinner, Melbourne, 4 April 2017. * * * Good evening. On behalf of the Reserve Bank Board I would like to warmly welcome you all to this dinner. We are very pleased that leaders from the worlds of politics, academia and the community sector, as well as from business, have been able to join us tonight. Having leaders join us from right across the community is important to us, as the decisions made by the Reserve Bank Board and by the Bank affect all Australians. Price stability, financial stability, sustainable growth and employment, and a well-functioning payments system matter to all of us. Each of these is important to our collective prosperity. So thank you all for being here tonight. This is the first of these dinners that I have had the honour of hosting. A particular privilege is to be able to do so in Melbourne, where we had our Board meeting today at our offices on the corner of Exhibition and Collins streets. Four of our nine Board members are based in Melbourne, with Carol Schwartz recently joining Cath Tanna, Kathryn Fagg and Ian Harper on the Reserve Bank Board. It was more than 30 years ago that we last had four residents of Melbourne on this Board and, on that occasion, it was only for a very short period. At our meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent. As usual, the reasons for our decision were set out in the statement issued shortly after the meeting. I don’t propose to run through all the issues that were considered by the Board. But there are two issues that I would like to talk about. The first is the improvement in the global economy. Business and consumer sentiment have lifted in many countries and global trade and industrial production have picked up as well. Commodity prices are also higher than they were for most of last year. Headline inflation rates have returned to near normal levels in many countries, boosted by higher oil prices. And the point of maximum global monetary stimulus looks to have passed. Given all this, at the G20 meetings that the Treasurer and I attended in Baden-Baden in Germany two weeks ago, the tone was much more positive than it had been at previous meetings. Encouragingly, over recent months forecasts for global growth have been revised up, not down as has been the case for the past four years. So this is a better position than we found ourselves in this time last year. There are, of course, still some clouds on the horizon. One that dominated discussion at the G20 meetings was a possible retreat from an open rules-based international trading system. If this were to occur it would, clearly, be bad for Australia and the world economy. The positive aspect, though, of these discussions is that they have generated a renewed focus in some countries, including in most emerging market economies, on the importance of the open international trading system. We have a lot riding on this being the outcome. The improvement in the global environment is helping us here in Australia. Commodity prices are up and there has been some improvement in business sentiment as well. And investment outside the resources sector looks to be gradually lifting after being weak for many years. So this is positive news. Labour market conditions, though, remain pretty soft. Growth in employment is slow and wage growth is the lowest in some decades. We will want to see an improvement here 1/4 BIS central bankers' speeches before we can be confident that growth in the overall economy is strengthening. We will also need to assess the effects on the economy from the damage and disruption from Cyclone Debbie in Queensland and the floods in northern New South Wales. It is still too early though for a full assessment to be made. The second issue that I would like to talk about is the level of household debt and the housing market. This is something we have been focused on for some time. The level of household debt in Australia is high and it is rising. Over the past year the value of housing-related debt outstanding increased by 6½ per cent. This compares with growth of around 3 per cent in aggregate household income. The result has been a further rise in the ratio of household debt to income, from an already high level. In aggregate, households are coping reasonably well with the higher debt levels. Arrears rates remain low and many households have built up sizeable buffers in mortgage offset accounts. At the same time, though, slow growth in wages is making it harder for some households to pay down their debt. For many people, the high debt levels and low wage growth are a sobering combination. In the housing market, conditions continue to vary considerably across the country. The Melbourne and Sydney markets are very strong and prices are increasing briskly. In contrast, conditions are more subdued in most other cities and, in some areas, most notably Perth, prices have declined. Nationally, growth in rents is the lowest for some decades. So it’s a complex picture and there is not a single story that applies across the country. But, as is often the case in economics, it largely comes down to supply and demand. On the demand side, population growth in Australia – especially in our largest cities – picked up unexpectedly in the mid 2000s and it is only in the past couple of years that the rate of home building has responded. This imbalance was compounded by insufficient investment in the transport infrastructure needed to support our growing population. Nothing increases the supply of well-located land like good transport links. Underinvestment in this area is one of the factors that has pushed housing prices up. Put simply, the supply side simply did not keep pace with the stronger demand side. The result has been higher prices. Not surprisingly, the rising prices have encouraged people to buy residential property as an investment in the hope of ongoing capital gains. With global interest rates so low, many investors have found it attractive to borrow money to invest in appreciating residential property. This has reinforced the upward pressure on prices. This configuration of ongoing increases in indebtedness and rising housing prices has been discussed at length by the Council of Financial Regulators. This council, which I chair, brings together the heads of the RBA, APRA, ASIC and the Australian Treasury. The concern has not been that these developments have posed a risk to the stability of our financial system. Our banks are resilient and they are soundly capitalised. Instead, the concern has been that the longer the recent trends continued, the greater the risk to the future health of the Australian economy. Stretched balance sheets make for more volatility when things turn down. Given this, over the past couple of years there has been a concerted effort by APRA to encourage lenders to strengthen their lending standards. This followed deterioration in these standards a few years ago. Also, at the end of 2014, when growth in investor lending was accelerating, APRA announced that it would pay very close attention to lenders whose investor loan portfolios were growing faster than 10 per cent. It did so with the full support of the RBA. This guidance helped pull the whole system back and has made a positive contribution to overall financial stability. So too has ASIC’s focus on responsible lending. These measures constrained some higher-risk lending and reinforced the message to lenders that they need to take a system2/4 BIS central bankers' speeches wide focus in their risk assessments. Notwithstanding this, given recent trends and the heightened risk environment, APRA announced some further measures last Friday. Again, it did this with the full support of the Council of Financial Regulators. There are two parts of APRA’s announcements that I would like to draw your attention to. The first is the need for lenders to have a very strong focus on serviceability assessments. Despite the focus on this area over recent times, too many loans are still made where the borrower has the skinniest of income buffers after interest payments. In some cases, lenders are assuming that people can live more frugally than in practice they can, leaving little buffer if things go wrong. So APRA quite rightly has said that lenders can expect a strong supervisory focus on loans with a very low net income surplus. The second area is interest-only lending. Over the past year, close to 40 per cent of the housing loans made in Australia have not required the scheduled repayment of even one dollar of principal at least in the first years of the life of the loan; only interest payments are required. This is unusual by international standards. In some countries, repayment of at least some principal is required on all housing loans for the entire life of the loan. In other countries, interest-only loans are available only if the borrower has already contributed a fair degree of equity. So this is one area where Australia stands out. We are not unique in this area, but we are unusual. There are a couple of factors that help explain the popularity of interest-only loans in Australia. One is the flexible nature of Australian mortgages. Many people with interest-only loans make significant payments into offset accounts rather than explicitly paying down principal. This flexibility, which is of value to many people, isn’t available in most countries. A second factor is the taxation arrangements that apply to investment in residential property in Australia. Last week APRA stated that it expected that new interest-only loans should account for no more than 30 per cent of the flow of new loans. It also stated that institutions should place strict limits on interest-only loans with high loan-to-valuation ratios. Like the earlier ‘speed limits’ on investor lending, these new requirements should help the whole system pull back to a more sustainable position. A reduced reliance on interest-only loans in Australia would be a positive development and would help improve our resilience. With interest rates so low, now is a good time for us to move in this direction. Hopefully, the changes might encourage a few more people to think about the merit of taking out very large interest-only loans when interest rates are near historical lows. So the RBA welcomes these latest changes. It is important, though, that we are all realistic about what these and other prudential measures can achieve. As I said before, the underlying driver in our housing market is the balance between supply and demand. The availability of credit is undoubtedly a factor that can amplify demand, but it is not the root cause. This assessment is consistent with the observation that housing market dynamics currently differ significantly across the country, despite Australia having nationwide financial institutions and the level of interest rates being the same across the country. It is hard to escape the conclusion that we need to address the supply side if we are to avoid ever-rising housing costs relative to our incomes and to avoid the attendant incentive to borrow that is created by rising housing prices. The various prudential measures do not address the underlying supply-demand issues. But they can reduce the risk from the financial side of the housing market while the underlying issues are addressed. These prudential measures help lessen the amplification of the cycle we get from borrowing and reduce the risk of developments on the financial side weakening the resilience that 3/4 BIS central bankers' speeches our economy has exhibited for many years. Ideally, this would be achieved by financial institutions acting themselves, without the need for prudential guidance. But sometimes prudential guidance can help the whole system adjust. The calibration of this guidance is not precise or straightforward so we need to keep matters under review. The Council of Financial Regulators will continue to assess how the system responds to the various measures so far. It would consider further measures if needed. As I have said, though, in the end addressing the supply side of the housing market is likely to prove a more durable way of dealing with the concerns that people have about debt and housing prices than detailed supervisory guidance. So that is enough on debt and housing. Before finishing, I would like to recognise that tomorrow we are having the official opening of our new banknote distribution centre and vault at Craigieburn, in outer Melbourne. This new centre is an important investment for us in Victoria. It will help us manage the task of issuing and storing banknotes nationally for many years to come. The new facility is built around a very large vault and as you can imagine, it is highly secure. It also uses the latest technology and is our first major investment in banknote storage and distribution for decades. As I hope you are aware, we are currently in the process of upgrading our banknotes to stay ahead of counterfeiters. Counterfeiting rates in Australia remain pretty low but they are creeping up. The new $5 note came out in September last year and the public reaction has been favourable. We are proud of these new notes, not just of the design but also of the high-tech security features. The new $10 will be issued from September and the $50 next year. As you can imagine, issuing a new series of banknotes is a huge logistical exercise. There are currently 1.5 billion individual banknotes on issue. That averages 62 per person in Australia. We also hold large contingency stocks, which we needed during the financial crisis when the demand for banknotes surged. It might come as a surprise to you to learn that, despite all the talk of a cashless society and electronic payments, the value of banknotes on issue in Australia, relative to GDP, is the highest that it has been in 50 years. Australians have come to rely on our secure and high-quality banknotes. Our new state of the art facility at Craigieburn will help us manage the storage and distribution of these notes. Thank you and enjoy your dinner and conversation. 4/4 BIS central bankers' speeches | reserve bank of australia | 2,017 | 4 |
Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Australian Financial Review Banking and Wealth Summit, Sydney, 6 April 2017. | Guy Debelle: Recent trends in Australian capital flows Speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the Australian Financial Review Banking and Wealth Summit, Sydney, 6 April 2017. * * * Thanks to Sue Black, Blair Chapman and Callan Windsor for their help in preparing this talk. Introduction Thanks to the AFR for inviting me to speak here today. I’m not going to talk about housing, I’m going to talk about something a bit more slow moving and lower frequency and that is capital flows to and from Australia and how the country funds its level of investment, which exceeds its level of aggregate saving. Though in saying that, it is worth noting that the aggregate level of saving in Australia is actually pretty high compared to other countries, it is just that investment is even higher. For more than a century, Australia’s high level of investment relative to saving has been supported by capital inflows from the rest of the world.1 These net capital inflows are the financial counterpart to Australia’s current account deficit. Foreign investment has been instrumental in expanding our domestic productive capacity and has been attracted by the favourable riskadjusted returns on offer here. Although net capital inflows have been a consistent feature of Australia’s balance of payments, the composition of both the inflows, as well as the outflows when Australians invest offshore, has varied substantially over time. When I spoke about capital flows a few years ago, I discussed the significant changes in the composition of capital flows that had taken place since 2007.2 At that time, I highlighted three noteworthy developments: a marked increase in foreign direct investment in the mining sector associated with the mining investment boom; the significant change in flows to the Australian banking sector from sizeable inflows pre-crisis to around zero; and a substantial increase in foreigners’ purchases of Australian government debt (Graph 1). 1/9 BIS central bankers' speeches To a large degree, these trends have continued over the past three years (Table 1). But under the surface, there have been some significant changes in the composition of these flows in recent years. Today I would like to highlight some of these. A forthcoming RBA Bulletin article will discuss these trends in more detail. 2/9 BIS central bankers' speeches Mining Sector From 2008, a significant share of mining investment expenditure was funded through foreign direct investment in the form of reinvested earnings during a period when profitability in the mining sector was particularly high. In the balance of payments, these reinvested earnings – essentially calculated as profits less dividends – are generally treated as being notionally distributed to foreign owners in the net income component of the current account. The foreign owners are then deemed to notionally reinvest back into the firm. These notional capital flows are recorded in the financial account.3 The money does not necessarily flow in and out of the country, it is just recorded as such in the balance of payments. The net capital inflows to the mining sector during the investment phase reflected the combined effect of the mining sector’s high profitability (and low dividend payout ratio), its tendency to fund investment from internal sources and the very high degree of foreign ownership.4 In recent years the net inflows to the mining sector have continued to be large despite the large decline in mining investment spending from 9½ per cent of GDP in 2012 to around 3½ per cent of GDP currently. The inflows have continued, even as mining profits have declined with the fall in commodity prices (until very recently).5 The continued strength of capital inflows has been supported by ongoing investment related to large liquefied natural gas (LNG) projects. LNG projects have made up a larger share of resource investment during this period than previously and many of these projects have an even higher foreign ownership share than the overall sector. These LNG projects have typically involved new joint ventures, where the majority of participants are foreign entities and are likely to have limited existing domestic operations with which to fund investment through profits. Accordingly, these inflows have mostly been in the form of direct funding from offshore rather than reinvested earnings. In this context, it seems reasonable to expect net capital inflows to the mining sector to moderate 3/9 BIS central bankers' speeches in the future, with capital flows to the mining sector in recent quarters already starting to taper. This follows the transition of a number of large LNG projects from the investment phase into the production and export phase. While the increase in exports will support profits and, therefore, notional capital inflows to the mining sector, some of these profits are likely to be paid out to offshore owners as dividends rather than reinvested, an issue I will return to later when discussing the net income deficit. Public Sector Turning to the public sector, foreigners have remained ongoing purchasers of Australian government debt, with the level of holdings continuing to rise over the past couple of years. Flows into government bonds have nonetheless moderated, and have not kept pace with the increase in net issuance. At face value, the headline statistics show that the foreign ownership share of government bonds has declined by around 20 percentage points since its peak in 2012. However, the extent of the decline is overstated. Part of this decline is a reflection of foreigners becoming considerably more active in the management of their government bond holdings, rather than a decreased appetite to hold Australian government bonds. In particular, part of the decline in the foreign ownership share reflects an increase in collateralised lending of Australian Government Securities (AGS) to Australian repo dealers. 6 Such lending activity – which grew particularly strongly over 2013–14 – is captured in the statistics as a sale of AGS by a foreigner to their domestic counterparty. This is despite economic ownership remaining with the foreign lender (who has the obligation to buy back similar securities at some stage in the future). Adjusting the level of foreign ownership to account for this collateralised lending shows that the decline in the foreign ownership share of AGS has been around 5 percentage points smaller (Graph 2). 4/9 BIS central bankers' speeches Banking Sector The aggregate pattern of capital flows to the banking sector has not changed materially since I last spoke on this topic. Since 2014 – and indeed over the period since the financial crisis – there have been minimal net capital flows to or from the banking sector. Following the shift away from offshore wholesale debt towards domestic deposits that took place in the wake of the global financial crisis, the funding composition of banks has remained relatively stable. But notwithstanding this stability, recently there have been two noteworthy developments relating to short-term debt, both stemming from regulatory reforms. Firstly, over the past year or so, Australian banks have reduced their short-term debt issuance in preparation for the introduction of the Net Stable Funding Ratio (NSFR) next year (Graph 3). The NSFR provides an incentive for banks to shift to sources of funding considered to be more stable and away from sources such as short-term wholesale liabilities. 5/9 BIS central bankers' speeches Secondly, the composition of Australian banks’ short-term offshore funding has also changed following the implementation of US Money Market Fund (MMF) reforms by the Securities and Exchange Commission in October 2016. As a result of these reforms, the value of assets under management of prime MMFs (those that lend to banks) has fallen by US$1 trillion or around 70 per cent over the past couple of years. Some prime funds have switched to become government-only funds, that is, funds that invest only in US government debt. At the same time, investors have allocated away from prime funds to government-only funds. Although prime MMFs have maintained their exposure to Australian banks relative to banks globally (at around 8 per cent of total MMF exposures to banks), their holdings of Australian bank debt have declined from around US$100 billion to under US$30 billion currently. However, in aggregate, Australian banks have continued to raise almost as much short-term funding from US commercial paper markets, despite the decline in MMFs. They have been able to tap other investors, in particular US corporates with large cash holdings, such as those in the technology sector. Australia’s Net Foreign Liability Position Having talked about capital flows, I will now turn to the stocks, which are the accumulation of all these flows (plus valuation effects). Australia’s net foreign liability position has been relatively stable as a share of GDP for more than a decade, before increasing a little recently to be around 60 per cent of GDP (Graph 4). Slightly more than all of Australia’s net liabilities are in the form of debt as the country has had a small net equity position in recent years. That is, since 2013, the level of Australian investment in foreign equity has exceeded the level of foreign investment in 6/9 BIS central bankers' speeches Australian equity. This reflects the sizeable offshore equity investment of the Australian superannuation sector as well as foreign exchange valuation effects, with the depreciation of the Australian dollar since 2013 increasing the Australian dollar value of our foreign equity investments. Today the majority of Australia’s debt liabilities are long-term, which is a significant change from a decade ago. Long-term debt liabilities are currently around 50–55 per cent of GDP, up from around 30 per cent prior to the financial crisis. The post-crisis shift towards longer-term debt was a result of two factors: banks lengthening the tenor of their debt on issue as well as the shift from bank debt towards government debt, which tends to have a relatively longer tenor. 7 Short-term debt liabilities are around their lowest share of GDP in two decades. Net Income Deficit I will finish by looking at the cost of servicing those liabilities. Over recent years, one of the more interesting trends has been the decline in the net income deficit. The net income deficit reflects the returns on foreign holdings of Australian assets compared with Australian holdings of foreign assets, be it in the form of interest, dividends or reinvested earnings. Australia has had a net income deficit since at least 1960 – a direct consequence of the net foreign liability position. Since late 2010, Australia’s net income deficit, as a per cent of GDP, has narrowed to be around its lowest level since the Australian dollar was floated (Graph 5). This has been associated with a 7/9 BIS central bankers' speeches narrowing of the current account deficit to its lowest share of GDP since the early 1980s. There are two distinct periods with different drivers behind this. The narrowing in the net income deficit from late 2010 to late 2013 mostly reflected a decline in income payments on Australians’ foreign debt and equity liabilities The lower average yield paid on Australian foreign debt was due to a combination of declines in Australian interest rates and an increase in the share of Australia’s foreign debt attributable to the Australian Government, which pays a lower rate of interest than private sector borrowers. The decline in the payments on equity liabilities was a result of lower profitability of the mining sector. Because Australia’s mining sector is majority foreign owned, a reduction in the profitability of that sector gives rise to smaller payments to the foreign owners, either in the form of dividend payments or reinvested earnings, thereby reducing the net income deficit. Since 2013, the reduction in the net income deficit has instead reflected an increase in returns on Australian residents’ offshore equity holdings. These increased returns are directly related to the determinants of the shift towards a net equity asset position that I just touched on: namely, continued flows into offshore equity by Australian superannuation funds and the depreciation of the exchange rate, which increases the Australian dollar value of dividend receipts. In the most recent national accounts, profits of private corporations rose by more than 15 per cent – the second largest increase in the history of the accounts – driven by a huge rise in profitability in the mining sector, in turn a reflection of the recent sharp rise in the prices of coal and iron ore. Based on company announcements, some of these profits are likely to be distributed to foreign owners as dividends. Moreover, to the extent that mining sector profits 8/9 BIS central bankers' speeches remain high over the next quarter or so, we could expect to see income outflows as these profits are distributed to foreign owners, all other things being equal. This is likely to increase the net income deficit in coming quarters, but not contribute to gross capital inflows to the mining sector, in contrast to previous periods of high profitability, when profits were reinvested to fund increased investment spending. Concluding Remarks To conclude, the main purpose of my speech today has been to highlight some trends in capital flows that have taken place over the past few years. By and large these trends have, on the surface, continued the patterns of previous years, but disaggregating a little further reveals some noteworthy trends. Firstly, sizeable capital inflows have continued to fund mining investment, in particular large LNG projects. Whereas these (notional) flows during the mining investment boom mostly reflected reinvested earnings, much of the more recent flows have been (actual) transfers from offshore affiliates. As these LNG projects transition into the production and export phase, we would expect to see these inflows moderate. Moreover, some of these profits are likely to be paid out to offshore owners as dividends rather than reinvested. Secondly, there has been continued appetite from foreign investors for Australian government debt, but this needs to be measured carefully given the increased participation of foreign investors in the domestic repo market. The third development has been the continuation of little net capital flows either to or from the banking sector, but, within that, a notable change in the composition of the investor base, particularly for short-term debt. 1 See Belkar R, L Cockerell and C Kent (2007), ‘Current Account Deficits: The Australian Debate ’, RBA Research Discussion Paper No 2007–02. 2 See Debelle G (2014), ‘Capital Flows and the Australian Dollar’, Address to the Financial Services Institute of Australia, 20 May. 3 See RBA (2011), ‘Box B: The Mining Sector and the External Accounts’, Statement on Monetary Policy, November, pp 42–44. 4 I have discussed this previously. See Debelle G (2013), ‘Funding the Resources Investment Boom’, Address to the Melbourne Institute Public Economic Forum, Canberra, 16 April. 5 The fall in commodity prices led to lower mining sector profits (after dividends). For a more detailed discussion, see Bergmann M (2016), ‘The Rise in Dividend Payments’, RBA Bulletin, March, pp 47–56. 6 See Becker C, A Fang and JC Wang (2016), 'Developments in the Australian Repo Market', RBA Bulletin, September, pp 41–46. 7 See Stewart C, B Robertson and A Heath (2013), ‘ Trends in the Funding and Lending Behaviour of Australian Banks’, RBA Research Discussion Paper No 2013–15. 9/9 BIS central bankers' speeches | reserve bank of australia | 2,017 | 4 |
Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the RMB Global Cities Dialogue Dinner, Sydney, 27 April 2017. | Philip Lowe: Renminbi internationalisation Remarks by Mr Philip Lowe, Governor of the Reserve Bank of Australia, to the RMB Global Cities Dialogue Dinner, Sydney, 27 April 2017. * * * I would like to thank Laura Berger-Thomson, Eden Hatzvi, Chris Ryan and Callan Windsor for assistance in the preparation of these remarks. It is an honour for me to be able to speak at this Renminbi (RMB) Global Cities Dialogue. I would like to congratulate the Department of Premier and Cabinet in New South Wales and the Sydney for RMB Committee for putting this dialogue together. I would also like to offer a very warm welcome to Sydney to those of you who have travelled from afar, especially those of you from other offshore RMB centres. We are all here to discuss the internationalisation of the Chinese currency. This is an important topic. I say this for two reasons. The first is that the internationalisation of the RMB and the associated liberalisation of the Chinese capital account have significant implications for the global financial system. Indeed, it is likely that the internationalisation of the RMB will be one of the biggest forces shaping the global financial system over the next decade or so. The second reason is that as the RMB becomes a truly global currency it is likely to change the way the Chinese economy operates. Australia’s experience provides an example here. In our own case, the internationalisation of the Australian dollar played an important role in shaping the development of the Australian economy over the past three decades or so. The internationalisation of our currency was a by-product of the move to a floating exchange rate and the abolition of capital controls. For us, it has been a positive experience. My expectation is that one day China too will be able to make the same claim. It is easy to appreciate why the Chinese authorities have sought to have an internationalised currency. As one of the world’s largest economies – and one that continues to grow in relative importance – it is understandable that China wishes to see the RMB take its place as one of the world’s truly global currencies. There are some clear advantages of being in this position. Mainland China’s financial markets will be deeper and more liquid, lowering the cost of finance to business. And there’s an advantage in being able to use your own currency in international trade and have global prices quoted in your currency. Being a major reserve currency can also help lower the cost of external financing. So China’s ambition is readily understandable. China is clearly making progress towards achieving this ambition. Given this, tonight I would like to talk first about that progress and then about some of the challenges and opportunities that lie ahead. Progress When we speak of an internationalised currency, what we typically have in mind is a currency that is used frequently in international trade and investment transactions between residents and non-residents and also in transactions that involve only non-residents. An internationalised currency can’t be achieved overnight. It takes time. It takes time for nonresidents to be comfortable using another currency. They need to have the hedging instruments available to manage risk effectively and a degree of familiarity with the foreign currency. It also takes time for the home authorities to be comfortable allowing their currency to be freely bought and sold by non-residents. So internationalisation is not something that occurs quickly. For the RMB there has been more progress in the use of the currency in transactions between 1/5 BIS central bankers' speeches residents and non-residents than there has been in its use for transactions between nonresidents only. This is particularly so on the trade side, as the Chinese authorities have been encouraging the use of the RMB for trade invoicing and settlement for quite some time. The use of the RMB for trade transactions has been facilitated by the establishment of offshore RMB centres, which provide a link between offshore markets and the mainland. As you are aware, these centres are a unique feature of the RMB internationalisation process and are an obvious impetus for this dialogue.1 Importantly, market participants should have the confidence to use the RMB freely within these centres, as many of these centres have RMB swap facilities with the People’s Bank of China (PBC). As such, they play a role in facilitating RMB transactions between non-residents. That said, there has recently been a decline in some measures of offshore RMB activity, which I will touch on in a moment. Consistent with the experience of other currencies, the increased use of the RMB in trade transactions has led to an increase in RMB-denominated financial transactions between mainland residents and non-residents.2 Most foreign financial institutions now have access to China’s bond markets, including, since last year, in the way previously available only to central banks and sovereign wealth funds. Nevertheless, domestic bonds purchased by foreign investors only account for around 1–1½ per cent of the market, although the market itself has expanded quickly. The authorities also intend to create a link between the bond markets in mainland China and Hong Kong later this year. In addition, as of earlier this year foreign investors are permitted to participate in the domestic foreign exchange derivative market to hedge the currency risk they take on as part of their bond investments. Foreign investors also have access to China’s equity markets through programs such as the Shanghai and Shenzhen Stock Connect schemes with Hong Kong. The stock connect schemes have facilitated capital outflows from China, alongside other schemes allowing institutional investors to invest offshore. Reflecting the progress that has been made, last year the RMB entered the basket of currencies that determine the value of the IMF’s Special Drawing Right. This followed the IMF’s decision in late 2015 to designate the RMB as ‘freely usable’. Not surprisingly, an increasing number of countries, including Australia, invest a portion of their foreign reserves in RMB. I note, however, that according to the IMF’s latest figures, the total value of foreign reserves invested in Australian dollars is still significantly higher than invested in RMB. I expect this to change over time. Our local RMB market has also been developing, albeit from a low base. Recently published survey data collected by the RBA show that the value of RMB deposits held with Australianresident banks rose strongly over 2015 and has been broadly unchanged over the past year, at around RMB30–40 billion.3 Consistent with this, annual data from the Australian Bureau of Statistics show that the share of Australia’s trade with China invoiced in RMB has continued to rise in recent years. In contrast to the experience here in Australia, the share of China’s total trade settled in RMB has declined over recent times. After peaking at almost 30 per cent in mid 2015, that share is currently around 15 per cent. The decline in the share of RMB payments for imports has contributed to a decline in the stock of RMB deposits in the offshore centres given that supply of RMB to these centres is largely through RMB trade payments. As Dr Ma touched on earlier today, part of this rise and subsequent fall in offshore RMB deposits reflects changed expectations about the future path of the RMB. But there has also been some underlying growth in demand for offshore RMB deposits for transactional purposes, with investors actively seeking to manage their exposure to exchange rate fluctuations. So putting all this together, there has been significant progress on many fronts. Indeed, there has 2/5 BIS central bankers' speeches been more progress than many observers expected. There is, though, still some way to go for the RMB to be a truly internationalised currency. Challenges and Opportunities An obvious question then is how to build on the progress that has been made. One lesson from experience elsewhere is that having an internationalised currency requires an open capital account. It requires allowing domestic citizens to buy and sell assets overseas and allowing non-residents to buy and sell domestic assets. The flows associated with these transactions generate depth in financial markets and provide a stimulus to the development of hedging markets. This then encourages more transactions: a form of virtuous circle develops. This was certainly the case here in Australia with the internationalisation of our currency. Interestingly, though, at no point did we have a strategic objective of having an internationalised currency. Instead, it happened rather organically as a result of market forces in an open system. China has been gradually moving in this direction, but the process of opening up has its challenges. Two of these are worth pointing out. The first is managing the volatility in capital flows that can be associated with a more open capital account. The second is managing the implications for global markets and investment patterns. The first of the challenges is one that faces any country moving from a highly constrained system to a more liberal system. As the constraints are lifted, people adjust their portfolios in ways they previously could not. These adjustments can lead to sharp and disruptive movements in market prices, particularly exchange rates, especially when markets are still not fully mature. To date, the Chinese authorities have largely avoided this volatility in market prices, although changes in expectations for the path of the exchange rate have affected capital flows into and out of China. For a number of years up until mid 2014, the RMB had been considered a ‘one-way’ bet to appreciate against the US dollar. Foreign capital flowed into China as investors sought to take advantage of the higher returns available, but also the appreciation of the RMB. As this capital flowed into China, the central bank offset some of the upward pressure on the exchange rate by purchasing foreign currency and buying foreign assets. Over the past couple of years, though, things have changed, with the RMB depreciating against the US dollar, alongside persistent expectations for further depreciation. Chinese residents have taken advantage of some new freedoms to increase foreign investment and the depreciating exchange rate has increased their incentive to do this. Mainland companies also appear to have delayed their export receipts and pre-paid for imports in anticipation of the RMB being weaker in the future. And they have also boosted their foreign currency deposits by holding onto foreign currency trade receipts (rather than converting them to RMB) and using them to repay foreign currency loans. In response to these changes, the Chinese authorities have sold some of the foreign assets they purchased previously. As a result, China’s foreign currency reserves have declined from a peak of US$4 trillion in mid 2014 to around $US3 trillion now. Fewer foreign assets are now held by the central bank and more are being held by other Chinese entities. As the People’s Bank of China has stated, this is a desirable shift. The Chinese authorities are understandably concerned that, left unchecked, the turnaround in capital flows could be destabilising. As a result, there has been some tightening up in the ability of Chinese residents to purchase foreign assets. The available data, as well as reports from 3/5 BIS central bankers' speeches China, suggest that these measures have slowed the outflow of capital. It should not come as a surprise that the Chinese authorities are proceeding cautiously and have sought temporarily to slow outflows or inflows from time to time. While many countries have liberalised their capital account and made their exchange rate more flexible, few, if any, have done so without causing at least some disruption to their domestic financial system. Short-term controls arguably can have a positive effect on financial stability in China by reducing the risk of a disorderly currency adjustment and pressures in Chinese financial markets. But there is a balance to be struck here, as tightening up controls runs counter to the longer-run goal. One consideration is the signal that a tightening of controls, after several years of liberalisation, could send to investors about how the government perceives the balance of risks facing the economy. A broad based and persistent tightening of capital controls might also exacerbate domestic vulnerabilities, by causing domestic liquidity to be greater than might be desired from a strict macroeconomic management perspective. Ultimately, balancing these competing risks is a difficult task. The second challenge for China is dealing with the implications for the global financial system. Unlike the challenge of dealing with volatility, this challenge is not one that most other countries have faced. It is an issue for China because of its size. When Australia opened its capital account the rest of the world hardly paid attention. But this is not the case for China. The rest of the world is watching and it has a strong interest in the outcome. Chinese gross portfolio flows remain small relative to the size of its economy. As my predecessor, Glenn Stevens, noted, if China’s gross portfolio flows were equivalent to 5 per cent of GDP in 2015 – the figure for many other countries in Asia and a bit less than that for Australia – China would account for a little more than one-fifth of global portfolio flows.4 Because of China’s size, investment by Chinese entities abroad has the potential to affect the prices of many assets significantly. We have already seen some signs of this with, for example, housing prices in some cities being affected by the inflow of Chinese money. The nature of the foreign assets owned by Chinese entities is also changing, as the central bank has a different portfolio composition from that of most other Chinese entities. In many countries, a related issue is the purchase of domestic assets by Chinese state-owned enterprises. There have been a few high-profile cases where governments have blocked deals by Chinese state-owned enterprises. But, by and large, most countries, including Australia, have welcomed Chinese investors in a wide range of sectors. Chinese capital is helping to build businesses and stronger trade links. So there are a lot of issues to be managed here. Conclusion To conclude, China is going through an important transition. It was not that long ago that the Chinese currency could be used only within China’s borders. In contrast, today China has the ambition of having a global currency. The effects of this transition – involving the internationalisation of the RMB and the opening up of the capital account – could ultimately be as wideranging as were the effects of China’s ascension to the World Trade Organisation. Managed well, this transition can be a win-win for both China and the rest of the world. Thank you. 1 Eichengreen B (2017), ‘The Renminbi Goes Global – The Meaning of China’s Money’, Foreign Affairs, 13 February. Available at www.foreignaffairs.com/reviews/review-essay/2017-02-13/renminbi-goes-global. 2 See, for example, Frankel (2012), ‘Internationalization of the RMB and Historical Precedents’, Journal of 4/5 BIS central bankers' speeches Economic Integration, 27(3), pp www.hks.harvard.edu/fs/jfrankel/RMBintnztnJEI2012pg329~365.pdf. 329–365, available at 3 These data can be found on the Statistical Tables page of the RBA website (Table B20). 4 Stevens G (2015), ‘Address to the Boao Forum for Asia Financial Cooperation Conference’, Audio address, Reserve Bank of Australia, Sydney, 30 July. Chinese gross portfolio flows were equivalent to a little less than 1 per cent of GDP in 2015. 5/5 BIS central bankers' speeches | reserve bank of australia | 2,017 | 4 |
Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Economic Society of Australia (QLD) Business Lunch, Brisbane, 4 May 2017. | Philip Lowe: Household debt, housing prices and resilience Speech by Mr Philip Lowe, Governor of the Reserve Bank of Australia, at the Economic Society of Australia (QLD) Business Lunch, Brisbane, 4 May 2017. * * * I would like to thank Gianni La Cava, Andre Liew and Fiona Price for assistance in the preparation of this talk. Thank you for the invitation to address the Queensland branch of the Economic Society of Australia. It is a pleasure to be in Brisbane again today. This afternoon I would like to talk about household debt and housing prices. This is a familiar topic and one that has attracted a lot of attention over recent times. It is understandable why this is so. The cost of housing and how we finance it matters to us all. We all need somewhere to live and for many people, their home is their largest single asset. Real estate is also the major form of collateral for bank lending. The levels of debt and housing prices also affect the resilience of our economy to future shocks. Beyond these economic effects, high levels of debt and housing prices have broader effects on the communities in which we live. The high cost of housing is a real issue for many Australians and can have serious side-effects. High levels of debt and high housing costs can also reinforce the existing distribution of wealth in our society, making social and geographic mobility more difficult. So it is understandable why Australians are so interested in these issues. At the Reserve Bank, we too have been focused on these issues in the context of our monetary policy and financial stability responsibilities. Our work has been in three broad areas. First, understanding the aggregate trends and their causes. Second, understanding how debt is distributed across the community. And third, understanding how the level of debt and housing prices affect the way the economy operates and its resilience to future shocks. This afternoon, I would like to make some observations in each of these three areas. Aggregate trends This first chart provides a good summary of the aggregate picture (Graph 1). It shows the ratios of nationwide housing prices and household debt to household income. Housing prices and debt both rose a lot from the mid 1990s to the early 2000s. The ratios then moved sideways for the better part of a decade – in some years they were up and in others they were down. Then, in the past few years, these ratios have been rising again.1 Both are now at record highs. 1 / 14 BIS central bankers' speeches Although the debt-to-income ratio has increased over recent times, the ratio of debt to the value of the housing stock has not risen. This reflects the large increase in housing prices and the growth in the number of homes. Over recent times, there has also been a substantial increase in the value of households’ financial assets, with the result that the ratio of household wealth to income is at a record high (Graph 2). So both the value of our assets and the value of our liabilities have increased relative to our incomes. 2 / 14 BIS central bankers' speeches Turning now to why the ratios of housing prices and debt to income have risen over time. 2 A central factor is that financial liberalisation and the lower nominal interest rates that came with the lower inflation of the 1990s increased people’s ability to borrow. These developments meant that Australians could take out larger and more flexible loans. By and large, we took advantage of this new ability, as we sought to buy the housing we desired. We could, of course, have used the benefit of lower nominal interest rates in the 1990s and the increased ability to borrow for other purposes. But instead we chose to borrow more for housing and this pushed up the average price of housing given the constraints on the supply side. The supply of well-located housing and land in our cities has been constrained by a combination of zoning issues, geography and inadequate transport. Another related factor was that our population was growing at a reasonable pace. Adding to the picture, Australians consume more land per dwelling than is possible in many other countries, although this is changing, and many of us have chosen to live in a few large coastal cities.3 Increased ability to borrow, more demand and constrained supply meant higher prices. So we saw marked increases in the ratios of housing prices and debt to household incomes up until the early 2000s. At the time, there was much discussion as to whether these higher ratios were sustainable. As things turned out, the higher ratios have been sustained for quite a while. This largely reflects the choices we have made as a society regarding where and how we live (and how much at least some of us are prepared to spend to do so), urban planning and 3 / 14 BIS central bankers' speeches transport, and the nature of our financial system. It is these choices that have underpinned the high level of housing prices. So the changes that we have seen in these ratios are largely structural. Recently, the ratios of housing prices and debt to household income have been increasing again. Lower interest rates both in real and nominal terms – this time, largely reflecting global developments – have again played some role. But there have also been other important factors at work over recent times. One of these is the slow growth in household income. During the 2000s, aggregate household income increased at an average rate of over 7 per cent (Graph 3). In contrast, over the past four years growth has averaged less than half of this, at about 3 per cent. Slower growth in incomes will push up the debt-to-income ratio unless growth in debt also slows. This partly explains what has happened over recent years. A second factor is that some of our cities have become major global cities. Reflecting this, in some markets there has been strong demand by overseas investors. A third factor has been stronger population growth. Population growth picked up during the mining investment boom and, although it subsequently slowed, it is still around ½ percentage point faster than it was before the boom (Graph 4). For some time the rate of home-building did 4 / 14 BIS central bankers' speeches not respond to the faster population growth; indeed, the response took the better part of a decade. The rate of home-building has now responded and we are currently adding to the housing stock at a rate not seen for more than two decades. Over time, this will make a difference. It is Melbourne and Sydney where population growth has been the fastest over recent times. Not surprisingly, it is these two cities where the price gains have been largest, and these price gains have helped induce more supply. Indeed, Victoria and New South Wales account for all of the recent upward movement in the national housing price-to-income ratio (Graph 5). In the other states, the ratio of housing prices to income is below previous peaks. So there is not a single story across the country. This is despite us having a common monetary policy for the country as a whole. Factors other than the level of interest rates are clearly at work. 5 / 14 BIS central bankers' speeches In summary then, the supply-demand dynamics have been pushing aggregate housing prices in our largest cities higher relative to our incomes. With interest rates as low as they have been, and prices rising, many people have found it attractive to borrow money to invest in an asset whose price is increasing. The result has been strong growth in borrowing by investors, with investors accounting for 30 to 40 per cent of new loans. This borrowing is not the underlying cause of the higher housing prices. But the borrowing has added to the upward pressure on prices caused by the underlying supply-demand dynamics. It has acted as a financial amplifier in some cities, adding to the already upward pressure on prices. The borrowing by investors is also obviously contributing to the rise in the aggregate debtto-income ratio. Just like in the early 2000s, there is again a discussion as to whether these increases will continue and whether they are sustainable. The distribution of debt I would now like to turn to the distribution of housing debt across households. This is important, as it is not the ‘average’ household that gets into trouble. At the Reserve Bank we have devoted considerable resources to understanding this distribution. One important source of householdlevel information is the survey of Household Income and Labour Dynamics in Australia (HILDA). If we look across the income distribution, it is clear that the rise in the debt-to-income ratio has been most pronounced for higher-income households (Graph 6). This is different from what 6 / 14 BIS central bankers' speeches occurred in the United States in the run-up to the subprime crisis, when many lower-income households borrowed a lot of money. It is also possible to look at how the debt-to-income ratio has changed across the age distribution. This ratio has risen for households of all ages, except the very youngest, who tend to have low levels of debt (Graph 7). Borrowers of all ages have taken out larger mortgages relative to their incomes and they are taking longer to pay them off. Older households are also more likely than before to have an investment property with a mortgage and it has become more common to have a mortgage at the time of retirement. 7 / 14 BIS central bankers' speeches We also look at the share of households with a debt-to-income ratio above specific thresholds. In 2002, around 12 per cent of households had debt that was over three times their income (Graph 8). By 2014, this figure had increased to 20 per cent of households. There has also been an increase, although not as pronounced, in the share of households with even higher debt-toincome ratios. 8 / 14 BIS central bankers' speeches Another dataset that provides insight into distributional issues is one maintained by the Reserve Bank on loans that have been securitised.4 This indicates that around two-thirds of housing borrowers are at least one month ahead of their scheduled repayments and half of borrowers are six months or more ahead (Graph 9). This is good news. But a substantial number of borrowers have only small buffers if things go wrong. 9 / 14 BIS central bankers' speeches At the overall level, though, nationwide indicators of household financial stress remain contained. This is not surprising with many borrowers materially ahead on their mortgage repayments, interest rates being low and the unemployment rate being broadly steady over recent years. At the same time, though, the household-level data show that there has been a fairly broad-based increase in indebtedness across the population and the number of highly indebted households has increased. Impact on economy and policy considerations I would now like to turn to the third element of our work: the implications of all this for the way the economy operates and its resilience. It is now commonplace to say that housing prices and debt levels matter because of financial stability. What people typically have in mind is that a severe correction in property prices when balance sheets are highly leveraged could make for instability in the banking system, damaging the economy. So the traditional financial stability concern is that the banks get in trouble and this causes trouble for the overall economy. This is not what lies behind the Reserve Bank’s recent focus on household debt and housing prices in Australia. The Australian banks are resilient and they are soundly capitalised. A significant correction in the property market would, no doubt, affect their profitability. But the stress tests that have been done under APRA’s eye confirm that the banks are resilient to large movements in the price of residential property. 10 / 14 BIS central bankers' speeches Instead, the issue we have focused on is the possibility of future sharp cuts in household spending because of stretched balance sheets. Given the high levels of debt and housing prices, relative to incomes, it is likely that some households respond to a future shock to income or housing prices by deciding that they have borrowed too much. This could prompt a sharp contraction in their spending, as they try to get their balance sheets back into better shape. An otherwise manageable downturn could be turned into something more serious. So the financial stability question is: to what extent does the higher level of household debt make us less resilient to future shocks? Answering this question with precision is difficult. History does not provide a particularly good guide, given that housing prices and debt relative to income are at levels that we have not seen before, and the distribution of debt across the population is changing. Given this, one of the research priorities at the Reserve Bank has been to use individual household data to understand better how the level of indebtedness affects household spending. The results indicate that the higher is indebtedness, the greater is the sensitivity of spending to shocks to income.5 This is regardless of whether we measure indebtedness by the debt-toincome ratio or the share of income spent on servicing the debt. If this result were to translate to the aggregate level, it would mean that higher levels of debt increase the sensitivity of future consumer spending to certain shocks.6 The higher debt levels also appear to have affected how higher housing prices influence household spending. For some years, households used the increasing equity in their homes to finance extra spending. Today, the reaction seems different. This is evident in the estimates of housing equity injection (Graph 10). In earlier periods of rising housing prices, the household sector was withdrawing equity from their housing to finance spending. Today, households are much less inclined to do this. Many of us feel that we have enough debt and don’t want to increase consumption using borrowed money. Many also worry about the impact of higher housing prices on the future cost of housing for their children. As I have spoken about previously, higher housing prices are a two-edged sword.7 They deliver capital gains for the current owners, but increase the cost of future housing services, including for our children. 11 / 14 BIS central bankers' speeches This change in attitude is also affecting how spending responds to lower interest rates. With less appetite to incur more debt for current consumption, this part of the monetary transmission mechanism looks to be weaker than it once was. There is, however, likely to be an asymmetry here. When the interest rate cycle turns and rates begin to rise, the higher debt levels are likely to make spending more responsive to interest rates than was the case in the past. This is something that we will need to take into account. In terms of resilience, my overall assessment is that the recent increase in household debt relative to our incomes has made the economy less resilient to future shocks. Given this assessment, the Reserve Bank has strongly supported the prudential measures undertaken by APRA. Double-digit growth in debt owed by investors at a time of weak income growth cannot be strengthening the resilience of our economy. Nor can a high concentration of interest-only loans. I want to point out that APRA’s measures are not targeted at high housing prices. 8 The international evidence is that these types of measures cannot sustainably address pressures on housing prices originating from the underlying supply-demand balance. But they can provide some breathing space while the underlying issues are addressed. In doing so, they can help lessen the financial amplification of the cycle that I spoke about before. Reducing this 12 / 14 BIS central bankers' speeches amplification while a better balance is established between supply and demand in the housing market can help with the resilience of our economy. There are some reasons to expect that a better balance between supply and demand will be established over time. One is the increased rate of home-building. As we are seeing here in Brisbane and some parts of Melbourne, increased supply does affect prices. This increase in supply is also affecting rents, which are increasing very slowly in most markets. A second reason is the increased investment in some cities, including in Sydney, on transport. Over time, this will increase the supply of well-located residential land, and this will help as well. And a third reason is that at some point, interest rates in Australia will increase. To be clear, this is not a signal about the near-term outlook for interest rates in Australia but rather a reminder that over time we could expect interest rates to rise, not least because of global developments. Over recent years, the low interest rates in Australia have helped the economy adjust to the winding down of the mining investment boom. They have helped support employment and demand through a significant adjustment in the Australian economy. We should not, though, expect interest rates always to be this low. It remains to be seen how the various influences on housing prices play out. Other policies, including tax and zoning policies, also have an effect. But increased supply and better transport could be expected to help address the ongoing rises in housing prices relative to incomes. These changes and some normalisation of interest rates over time might also reduce the incentive to borrow to invest in an asset whose price is rising strongly. To the extent that, over time, a better balance is established, we will be better off not incurring too much debt, and having housing prices go too high, while this is occurring. I want to make it clear that the Reserve Bank does not have a target for the debt-to-income ratio or the ratio of nationwide housing prices to income. As I spoke about earlier, there are good reasons why these ratios move over time. My judgement, though, is that, in the current environment, the resilience of our economy would be enhanced by an extended period in which housing prices and debt outstanding increased no faster than our incomes. Again, this is not a target or a policy objective of the Reserve Bank, but rather a general observation about how we build resilience. Many of you will be aware that these issues have figured in the deliberations of the Reserve Bank Board for some time. This is entirely consistent with our flexible medium-term inflation targeting framework. With a medium-term target, it is appropriate that we pay attention to the resilience of our economy to future shocks. In the current environment of low income growth, faster growth in household debt is unlikely to help that resilience. We have also been watching the labour market closely. The unemployment rate has moved up a little over recent months and wage growth remains subdued. Encouragingly, employment growth has been a bit stronger of late and the forward-looking indicators suggest ongoing growth in employment. We will want to see a continuation of these trends if the overall growth in the economy is to pick up as we expect. Stronger growth in incomes would of course also help people deal with the high levels of debt and housing prices. Overall, our latest forecast is for economic growth to pick up gradually and average around 3 per cent or so over the next few years. To conclude, I hope these remarks help provide some insight into the Reserve Bank’s thinking about housing prices and household debt. As household balance sheets have changed, so too has the way that the economy works. Both from an individual and an economy-wide perspective, 13 / 14 BIS central bankers' speeches we need to pay attention to how the higher level of debt affects our resilience to future shocks. Thank you. I look forward to your questions. 1 When balances in offset accounts are taken into account, the recent rise in household debt is less pronounced, although the household debt-to-income ratio has still risen to a record high. 2 For RBA analysis of this issue see Kohler M and M van der Merwe (2015), ‘Long-run Trends in Housing Price Growth’, RBA Bulletin, September, pp 21–30 and RBA (2003) ‘ Household Debt: What the Data Show’, RBA Bulletin, March, pp 1–11. 3 See RBA (2015), ‘Submission to the Inquiry into Home Ownership’, Submission to the House of Representatives Standing Committee on Economics Inquiry into Home Ownership, 25 June, and RBA (2014), ‘Submission to the Inquiry into Affordable Housing’, Submission to the Senate Economics References Committee Inquiry into Affordable Housing, 14 February. 4 These data, which go down to the level of the individual (anonymised) underlying loans, are collected by the Reserve Bank and assist in managing our exposures to asset-backed securities accepted in market operations. These data cover around one-quarter of the value of outstanding housing loans. 5 See La Cava G, H Hughson and G Kaplan (2016) ‘The Household Cash Flow Channel of Monetary Policy’, RBA Research Discussion Paper No 2016–12. 6 It is, however, worth pointing out that, at least to date, aggregate consumption has not been more volatile following the earlier increase in the debt-to-income ratio. 7 Lowe, P (2015) ‘National Wealth, Land Values and Monetary Policy’, Address to the 54th Shann Memorial Lecture, Perth, 12 August 2015. 8 See Byres W (2017) ‘Prudential Perspectives on the Property Market’, available at <www.apra.gov.au/Speeches/Documents/Prudential prespectives on the property market – 28 April 2017.pdf>, Remarks at CEDA’s 2017 NSW Property Market Outlook, Sydney, 28 April. 14 / 14 BIS central bankers' speeches | reserve bank of australia | 2,017 | 5 |
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